Edited version of your private ruling

Authorisation Number: 1012598765976

Ruling

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

Question

If a superannuation fund (the Fund) enters into a limited recourse borrowing arrangement (LRBA) with a related party of the Fund and no interest is charged over the term of the loan, will this give rise to non-arm's length income of the Fund?

Answer

Yes.

This ruling applies for the following period:

Year ending 30 June 2014

The scheme commences on:

During the income year ending 30 June 2014

Relevant facts and circumstances

The Fund is a regulated self-managed superannuation fund.

The trustee of the Fund (the Trustee) is a private company.

The Fund member (the Member) is the only member of the Fund and the only director of the Trustee.

The Trustee intends to purchase, on behalf of the Fund, a business real property (the Property) from a related party of the Fund for market value.

To fund the purchase of the Property, the Trustee will enter into an LRBA with the Member.

The Trustee will contribute 30% of the market value towards the cost of the property and the remaining funds will be borrowed from the Member.

The terms of the LRBA will be as follows:

• the loan is for a term of a number of years.

• for the first several years, repayment of interest only at the rate of 0%; and

• for the remaining years of the loan term, repayment of the principal in equal yearly parts.

The Property will be held on trust by the Custody Trust for the benefit of the Fund.

The Member is the sole director of the trustee of the Custody Trust.

The Custody Trust Bare Trust Deed (the Bare Trust Deed) provides that:

• The Trustee holds the Asset for the Beneficiary; and

• The Beneficiary is absolutely entitled to the benefit of the Asset together with all earnings, profits or gains accrued or to accrue in respect of the Asset.

The tenant of the Property is not related to the Fund. It is contemplated that the tenant will remain in the Property after the Trustee acquires the Property.

The tenant will pay rent at commercial rates.

Relevant legislative provisions

Reasons for decision

Summary

If the Fund enters into an LRBA with a related party of the Fund and no interest is charged over the term of the borrowing, the income derived by the Fund through entering into the LRBA will be non-arm's length income of the Fund.

Detailed reasoning

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) of the ITAA 1997 states 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:

A 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 section 272-5 of the ITAA 1936 states at paragraphs 13.4 to 13.7:

What is a vested interest?

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.

When is a vested interest indefeasible?

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 Custody Trust arising in respect of the Property. This view is based on the facts as stated above in paragraph 9 of the 'Relevant facts and circumstances'. If that conclusion were wrong, any income derived by the Fund as beneficiary of the Custody 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 Taxation¹ considered the term 'arrangement' as defined for the purposes of former subsection 273(7) of the 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 Custody Trust (and any derivation of income by the Fund through holding that entitlement) including:

• the establishment and operation of the LRBA between the Fund and the Member; and

• the establishment and operation of the Custody 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 Custody 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 the Member is:

• the only member of the Fund (beneficial owner);

• the sole director of the Trustee (the borrower);

• the sole director of the trustee of the Custody Trust (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 LRBA, 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:

• the Member is not by way of the charging of interest under the loan agreement, 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 loan; and

• rather than regular periodic repayments of the principal sum over the term of the loan, no repayments are to be made for the first five years.

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 Custody Trust is either:

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

• is less than under the proposed arrangement - on the basis that the Member might be expected to lend on commercial terms given the limited recourse nature of the loan. The income that might be expected to be derived by the Fund through the Custody 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 Custody 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.

¹ (2011) 195 FCR 416; [2011] FCAFC 118; (2011) 2011 ATC 20-277; [2012] ALMD 3059; (2011) 84 ATR 853.

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).