Edited version of your private ruling

Authorisation Number: 1012595001544

Ruling

Subject

Contribution and non-arm's length income

Questions

1. If the trustee of a superannuation fund (the Fund) enters into a loan agreement (the Loan Agreement) and borrows at a zero percent interest rate, will the discounted amount of interest be a superannuation contribution for the members of the Fund?

Answer:

No.

2. Will income received by the Fund from a bare trust (the Trust) by reason of its beneficial ownership of a property that:

(a) was acquired with the loan it borrowed at zero percent interest rate under the Loan Agreement; and

(b) is held by the Trust as custodian

be non-arm's length income of the Fund?

Answer:

Yes.

This ruling applies for the following period:

Income year ended 30 June 2014

The scheme commences in:

The second quarter of the income year ended 30 June 2014

Relevant facts and circumstances

The Fund is a self-managed superannuation fund.

Member A and Member B of the Fund (the Members) are also the individual trustees (the Fund Trustee) of the Fund.

In the 2013-14 income year a property in Australia (the Property) was acquired on behalf of the Fund from unrelated parties (the Vendors) for a specified amount.

The Property had been leased by the Vendors to another unrelated party for a number of years. That party uses the property in their business. The existing lease continues after the acquisition, and the annual rent will increase in accordance with the consumer price index.

Under a trust deed (the Deed), the Property is held upon trust for the benefit of the Fund Trustee (the Beneficiary). A private company is the trustee of the bare trust (the Trust). The Members are the directors of the private company.

Under the Deed, the trustee of the Trust has the right to grant security over and to charge, mortgage or pledge any assets of the Trust.

The Deed gives the Beneficiary the right to acquire legal ownership of the Property when it makes one or more payments.

It is further stated in the Deed that:

(a) the Beneficiary is absolutely entitled to all the assets of the Trust;

(b) the Beneficiary has an immediate and indefeasible vested interest in the income derived by the Trust from its assets and will be presently entitled to it and

(c) the Trustee may pay expenses or reimburse itself from the Trust in respect of acting as trustee.

A notification of mortgage executed by the trustee of the Trust as Mortgagor, and the Members as Mortgagee, in relation to the Property was lodged with the relevant land registry.

The Deed states that:

The Trustee holds the Fund and the income derived from the Fund upon the trusts and with and subject to the powers set out in this deed.

The word 'Fund' as quoted above is defined in the Deed as:

(a) the Initial Amount;

(b) the Original Asset; and

(c) all other money and property vested in the Trustee to be held upon the trusts of this deed.

The income from rent, net of expenses, receivable by the Trust for the benefit of the Fund, together with any investment returns such income may generate, will be distributed to the Fund.

Approximately half of the purchase price paid for the Property was met by cash held by the Fund. The balance (the Advance) was borrowed by the Fund Trustee (the Borrower) from the Members (the Lender) pursuant to a loan agreement (the Loan Agreement).

The Members are not borrowing any money from any third party to on-lend. The money they lent to the Fund was from their savings.

The 'Request for private ruling' states that the Loan Agreement is a limited recourse borrowing arrangement that satisfies section 67A of the Superannuation Industry (Supervision) Act 1993. The Loan Agreement provides that:

Despite any other provision of this document, the liability of the Borrower for the Amount Outstanding is limited to the aggregate amount available for payment or satisfaction of the Amount Outstanding from enforcement in respect of the Borrower's interest in the Property and the Lender is only entitled to enforce its rights in respect of any breach of any provision of this document to the extent necessary to:

(a) enforce their right in respect of the Property; and

(b) recover the proceeds of sale on disposal of the Property.

Under the Loan Agreement, the liability of the Borrower for any outstanding amount is limited to the Property, or the sale proceeds from the Property.

If there are insufficient funds to pay or satisfy any outstanding amount, under the Loan Agreement the Lender will have no right of recourse against any other assets of the Borrower for the deficiency.

The amount of the Advance, the rate of interest and the re-payment date are specified in the Schedule to the Loan Agreement:

Relevant legislative provisions

Income Tax Assessment Act 1997 295-160.

Income Tax Assessment Act 1997 Section 295-545

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

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 1936 Subsection 273(7) (repealed)

Superannuation Industry (Supervision) Act 1993 Section 67A

Superannuation Industry (Supervision) Act 1993 Section 109

Reasons for decision

Summary

The discounted amount of interest is not considered to be a superannuation contribution.

The income to be derived by the Fund through the Trust will be non-arm's length income of the Fund.

Detailed reasoning

Whether the discounted amount of interest is a superannuation contribution?

The Commissioner has set out his view of the meaning of contribution as it is used in relation to superannuation funds in Taxation Ruling TR 2010/1 titled Income tax: superannuation contributions. At paragraph 4 the Commissioner 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.

Whether or not the capital of the Fund will be increased as a result of the Fund not being required to pay interest on the money borrowed under the Loan Agreement will, therefore, need to be determined.

The Commissioner discusses his view of the ordinary meaning of 'borrow' and 'loan' in Self-Managed Superannuation Funds Ruling SMSFR 2009/2 titled Self-managed superannuation funds: the meaning of 'borrow money' or 'maintain an existing borrowing of money' for the purposes of section 67 of the Superannuation industry (Supervision Industry (Supervision) Act 1993. At paragraph 48 of that ruling the Commissioner recognises that while the obligation to pay interest may evidence the existence of a borrowing or loan of money it is not a necessary feature.

The fact that there is no obligation on the part of the Fund to pay interest on the loan under the Loan Agreement does not result in an increase in the assets of the Fund. Therefore the discounted amount of interest (i.e. the difference between the interest calculated using an arm's length interest rate and that using a zero percent interest rate) is not considered to be a superannuation contribution received by the Fund.

Consequently, the purpose of the Lender in offering a zero percent interest rate loan to the Fund Trustee does not fall for consideration if there is no increase in the capital of the Fund. The Commissioner is therefore of the view that the discounted amount of interest is not a superannuation contribution to the Fund.

Whether the income derived from this nil interest rate loan arrangement is considered non-arm's length income pursuant to section 295-550 of the ITAA 1997

Section 295-545 of the Income Tax Assessment Act 1997 (the ITAA 1997) provides that the taxable income of a complying superannuation fund is split into a non-arm's length component and a low tax rate component. The note to subsection 295-545(1) explains that a concessional rate of tax applies to the low tax component, while the non-arm's length component is taxed at the highest marginal rate. These rates are set out in the Income Tax Rates Act 1986.

Subsection 295-545(2) of the ITAA 1997 provides that the non-arm's length component for an income year is the entity's non-arm's length income for that year less any deductions to the extent that they are attributable to that income.

Pursuant to subsection 295-550(4) of the ITAA 1997, income derived by 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. Where income is derived through holding a fixed entitlement, 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.

Fixed entitlement to trust income

Under the Deed the trustee of the Trust is empowered to determine any amount received or disbursed, or any part of such amount, as income or capital of the Trust.

The Deed does not otherwise state whether the trustee of the Trust has a discretion to add any other entities as beneficiaries of the Trust and to determine whether part of the Trust's capital or income is to be distributed to such beneficiaries.

These, together with the other relevant clauses in the Deed, would indicate that the Fund holds a fixed entitlement to the income of the Trust for the purposes of subsection 295-550(5) of the ITAA 1997. If this is not the intention of the parties to the Deed, then any income derived by the Fund as a beneficiary of the Trust would be non-arm's length income of the Fund per se by reason of subsection 295-550(4).

Provided that the Trust will distribute 100% of its net income to the Fund, the Commissioner considers that, for the purposes of this private ruling, the Fund Trustee as the sole beneficiary of the Trust holds a fixed entitlement to the income of the Trust.

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 (2011) 195 FCR; [2011] FCAFC 118; (2011) 2011 ATC 20-277; [2012] ALMD 3059; (2011) 84 ATR 853 (Allen) considered the term 'arrangement' as defined for the purposes of former subsection 273(7) of the Income Tax Assessment Act 1936 (the ITAA 1936) - the immediate predecessor of subsection 295-550(5) of the ITAA 1997. As the definitions quoted above show, a 'scheme' includes any 'arrangement', and an 'arrangement' includes any 'agreement, understanding, promise or undertaking'.

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 as per (2011) 195 FCR 416, at 433-434; 2011 ATC 20-277, paragraph 69.

Similarly, for the purposes of applying subsection 295-550(5) of the ITAA 1997 to the present case, the scheme involves the series of steps undertaken by the parties that results in the Fund's acquisition of its fixed entitlement to the income of the Trust and any derivation of income by the Fund through holding that entitlement. These steps include the establishment and operation of the Loan Agreement between the Fund and the Lender (which includes the establishment and operation of the Trust in favour of the Fund in respective of each of the Property acquired partly with the borrowed money).

Further, those results are readily seen to be the consequence of the scheme. 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 Trust under a scheme and any income derived through holding that entitlement would be derived under the scheme.

Not dealing at arm's length

Subsection 995-1(1) of the ITAA 1997 provides that in determining whether parties deal at arm's length, consider any connection between them and any other relevant circumstances.

The expression 'not dealing with each other at arm's length' or similar expressions have been considered by the courts in numerous cases. In Federal Commissioner of Taxation v. AXA Asia Pacific Holdings Ltd [2010] FCAFC 134; (2010) 189 FCR 204; (2010) 2010 ATC 20-224; [2011] ALMD 2345; (2020) 81 ATR 180 (AXA case) Justice Dowsett of the Full Federal Court summarised propositions from those cases. In paragraph 26 of his judgment, published at 2010 ATC 20-224, he stated that:

I have no real difficulty with any of the propositions which emerge from those cases. They may be summarised 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;

• unrelated 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 the AXA case (2010) 189 FCR 204, at 231 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. The Members are:

(a) the individual trustees and the members of the Fund

(b) the Lender of the balance of the purchase price of the Property to the Fund and

(c) the directors of the trustee of the Trust;

Further, the Full Federal Court in Allen (2011) 195 FCR 416 at 434 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, that means that regard may be had to the establishment and operation of the Loan Agreement between the Fund and the Lender (which includes the establishment and operation of the Trust in favour of the Fund in respective of the Property acquired with the borrowed money).

Assessing the circumstances holistically, it is clear that the parties will not be dealing with each other in respect of the Loan Agreement as arm's length parties would do. Aspects which, taken together, the Commissioner considers leads to that conclusion include the following:

• The Lender is not, either by way of charging interest on the loan 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 Fund defaulting in re-paying the loan, given the limited recourse nature of the loan and lack of other security. If the Fund Trustee borrowed the amount from a financial institution instead, the latter would certainly take into account its own cost of providing the loan, the risk involved and the reasonable reward that the market can offer in a similar situation.

• Rather than making regular periodic re-payments of the principal sum borrowed from the Lender, the Fund is only required to make a single lump sum re-payment at the end of the loan term. While some financial institutions do allow re-payment of the principal sum to be deferred for a number of years, periodic interest-only re-payments must, however, be made by the borrower to the lender at the agreed rate of interest during that period. It is only in a situation where parties (often related to each other) are not dealing with each other at arm's length that the lending party will agree to have an absolutely interest free loan re-paid by the borrowing party in a lump sum after a considerable period of time.

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 the income that the Fund might have been expected to derive through the Trust would, in the Commissioner's view, either be 'nil' or be less than under the proposed arrangement on the following bases:

• Without being lent the balance of the purchase price of the Property by the Lender on the proposed terms and without borrowing the same amount from any other sources on commercial terms at a commercial rate of interest, the Fund Trustee would not be able, or would otherwise not be prepared, to proceed with purchasing the Property. The amount of the income that the Fund might have been expected to derive through the Trust would therefore be 'nil.

• If the Fund Trustee borrowed the balance of the purchase price of the Property from a financial institution at arm's length, the financial institution would charge a commercial rate of interest. This in turn would reduce the net income otherwise available to the Trust for distributing to the Fund.

• Without being lent the balance of the purchase price of the Property by the Lender on the proposed terms, the alternative for the Fund Trustee would be to purchase a property valued at no more than the Fund could afford using its own resources. In such a case it can reasonably be expected that the property so purchased would generate a smaller rental income as the utility value of a property to a prospective tenant would depend on its location, size and facilities which are normally reflected by its market value. In any event, the property so purchased would certainly not be rented by the same tenant of the Property for the same amount of annual rent as stated in the private ruling application.

• Instead of lending the balance of the purchase price of the Property to the Fund interest free, the Lender could invest the same amount in the Property jointly with the Fund as a co-owner and, as an arm's length dealing, share a pro rata portion of the rental income from the Property with the Fund accordingly. This would proportionately reduce the amount of the rental income that the Fund could otherwise receive under the proposed arrangement. The Lender would then include their share of the rental income in their own assessable income.

As the amount of the income that Fund will receive through the Trust is more than what the Fund might have been expected to receive under an arm's length dealing, paragraph 295-550(5)(b) of the ITAA 1997 is satisfied.

Consequently, the Commissioner considers that the income to be derived by the Fund through the Trust will be non-arm's length income of the Fund under subsection 295-550(5) of the ITAA 1997.

Copyright notice

© Australian Taxation Office for the Commonwealth of Australia

You are free to copy, adapt, modify, transmit and distribute material on this website as you wish (but not in any way that suggests the ATO or the Commonwealth endorses you or any of your services or products).