Edited version of private advice

Authorisation Number: 1012633428550

Ruling

Subject: Contribution and non-arm's length income

Questions

1. If the members of a superannuation fund (the Fund) lend money to the Fund through various limited recourse borrowing arrangements (LRBAs) at 0% interest rate, would the difference between the market interest rate and the lower rate of interest offered to the Fund be a contribution?

2. Will the income generated from investments acquired using various LRBAs be non-arm's length income of the Fund in accordance with section 295-550 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answers

1. No.

2. Yes.

This ruling applies for the following period:

Income year ending 30 June 2014

The scheme commences on:

On or after 1 July 2013

Relevant facts and circumstances

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

You have stated that the Fund is a complying superannuation fund.

The members of the Fund are Member 1 and Member 2.

The trustee of the Fund (the Fund Trustee) is a corporate entity.

The directors of the Fund Trustee are Member 1 and Member 2.

The Fund Trustee would like to make certain investments on behalf of the Fund. However, the Fund does not have surplus cash available to invest.

Member 1 and Member 2 (collectively referred to as the Lender) would like to lend their personal savings to the Fund Trustee to acquire, on behalf of the Fund, investments in:

• Australian and/or international managed funds;

• Australian listed securities; and

• direct/indirect property

The Fund Trustee proposes that the amount to be borrowed from the Lender will be split equally among each of the categories mentioned above. However, the amount for each category will be split further to invest in different classes of investments. For example, the amount for listed securities may have 10 different loan agreements of various amounts that in aggregate will equal the amount for listed securities. A separate loan will be used to acquire a particular entity's shares.

An 'SMSF Limited Recourse Loan Agreement' which is still in draft form (the Loan Agreement) will be used for each and every loan to be made by the Lender to the Fund Trustee (as the Borrower).

According to the Loan Agreement:

• The Lender will lend monies to the Borrower for the purpose of acquiring a Single Acquirable Asset including any incidental costs in relation to the acquisition of the Single Acquirable Asset.

• The Single Acquirable Asset and any Replacement Asset if allowed under the Superannuation Laws will be held by the Holding Trustee under the terms and conditions of the Holding Trust Deed including that the Borrower has an absolute beneficial entitlement to the Assets notwithstanding the legal title to the Single Acquirable Asset is held by the Holding Trustee.

• The loan of monies from the Lender to the Borrower is according to the terms and conditions of the Loan Agreement as set out in Schedule 1.

• The loan is non-recourse with the Lender to have recourse only against the Single Acquirable Asset held in the Holding Trust.

As far as relevant, the Loan Agreement also states:

• At the Commencement Date the Lender will loan Monies to the Borrower under the Loan Agreement to acquire a Single Acquirable Asset. The Loan Amount may be pursuant to a Line of Credit between the Lender and the Borrower. The Loan Amount is to be found in the Schedule to the Loan Agreement.

• The term of the Loan Agreement for a Loan Amount is as set down in the Schedule and is to be 20 (five years interest only with option to renew at every five year interval) years. The Lender and Borrower may by mutual agreement extend the Loan Agreement for any such period provided the Superannuation Laws allow and any extension does not result in a new loan but a continuation of this Loan Agreement.

• The interest rate for the Loan Agreement for the Loan Amount is Fixed Rate and currently set at 0% payable in arrears. At any time the Lender with the consent of the Borrower can change the interest rate. The Loan will be Interest Only with the option of the Borrower and with the consent of the Lender may be converted to a Principal and Interest Loan at any time.

With respect to the Loan Agreement the Commissioner has, for the purposes of this private ruling, relied on the following confirmation from you:

We confirm that wordings of each loan agreement will be same (except the loan amount, type of asset and the terms of the loan may differ).

A separate trust (the Holding Trust) will be established to hold each 'single acquirable asset' to be acquired.

A single corporate trustee will be appointed as the trustee of all the Holding Trusts (the Holding Trustee). The directors of the Holding Trustee will be Member 1 and Member 2.

A sample draft 'Holding Trust Deed of Establishment' (the Holding Trust Deed) will be used for establishing one or more Holding Trusts.

You have confirmed that the wording of all the Holding Trust Deeds will be the same for all the Holding Trusts to be established except that the Schedule in each case will be specific as to what asset will be acquired.

As to whether the Holding Trust Deed requires the Trustee under the proposed arrangement to distribute to the Beneficiary 100% of a Holding Trust's net income derived from the asset held on trust by the Holding Trust, you have advised that the trust, according to legal advice you received, is a custodian trust and will not have net income.

You have confirmed that all the income generated from assets acquired under the Loan Agreements will be reported in the Fund's income tax return.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 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 Part III, Division 6

Income Tax Assessment Act 1936 Former subsection 273(7)

Superannuation Industry (Supervision) Act 1993 Section 67

Superannuation Industry (Supervision) Act 1993 Section 67A

Superannuation Industry (Supervision) Act 1993 Subsection 67A(1)

Superannuation Industry (Supervision) Act 1993 Subsection 67A(2)

Reasons for decision

Summary

The difference between the market rate of interest and a lower interest rate offered to the Fund does not increase the capital of the Fund. Therefore, the discounted amount of interest is not considered to be a superannuation contribution to the Fund.

Income derived by the Fund through the Holding Trusts will be non-arm's length income of the Fund in accordance with subsection 295-550(5) of the ITAA 1997.

Detailed reasoning

Whether discounted amount of interest is superannuation contribution

The Commissioner has set out his view on the meaning of contribution as it is used in relation to superannuation funds in Taxation Ruling TR 2010/1 (TR 2010/1). 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.

Where, as here, 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 and no contribution is made to the superannuation fund under the arrangement.

Also, in Self Managed Superannuation Funds Ruling SMSFR 2009/2 (SMSFR 2009/2), the Commissioner discusses his view of the ordinary meaning of 'borrow' and 'loan'. 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 of the same.

Based on the above, the fact that there is no obligation on the part of the Fund to pay interest on the borrowings under the Loan Agreement does not result in an increase in the capital of the Fund. Therefore the discounted amount of interest (that is, the difference between the market rate of interest and 0% interest rate) is not considered to be a superannuation contribution received by the Fund.

Whether income derived by the Fund through the Holding Trusts is non-arm's length income pursuant to section 295-550 of the ITAA 1997of the Fund

Section 295-545 of 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.

Amounts of ordinary income or statutory income of a complying superannuation fund that are non-arm's length income of a fund are set out in subsection 295-550 of the ITAA 1997. Relevantly, income that is derived by a fund as a beneficiary of a trust is dealt with in subsections 295-550(4) and (5) of the ITAA 1997.

Pursuant to subsection 295-550(4) of the ITAA 1997, income derived by a complying superannuation fund 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 fund.

Where income is derived by a complying superannuation fund as a beneficiary of a trust through holding a fixed entitlement, subsection 295-550(5) of the ITAA 1997 provides that the income so derived is non-arm's length income of the fund if:

(a) the entity [the fund] 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 [words in bracket added]

(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

Taxation Ruling TR 2006/7 (TR 2006/7) explains what amounts are considered to be 'special income' under former section 273 of the ITAA 1936 which was repealed with effect from 1 July 2007. Former section 273 has been re-written, with some modifications, in section 295-550 of the ITAA 1997. To the extent that section 295-550 of the ITAA 1997 expresses the same ideas as former section 273, TR 2006/7 is also taken to be a ruling about section 295-550 of the ITAA 1997.

In accordance with paragraph 101 of TR 2006/7, if a complying superannuation fund derives income from a trust by way of the trustee or any other person exercising a discretion, the income distributed will be non-arm's length income under subsection 295-550(4) of the ITAA 1997.

A trust distribution to a complying superannuation fund will fall within subsection 295-550(5) of the ITAA 1997 rather than subsection 295-550(4) of the ITAA 1997 only if the fund's entitlement to the distribution does not depend upon the exercise of the trustee's, or any other person's discretion, that is, if the fund holds a fixed entitlement to the income of the trust .

In all cases, the determining factor in deciding if a fixed entitlement exists is the terms of the trust instrument under which the trust is constituted. In this case, that instrument is the Holding Trust Deed.

As far as relevant, the Holding Trust Deed states:

• The Trustee declares that it holds the Property on Holding Trust for the Beneficiary and the Trust is established by the Trustee's execution of this deed.

• The Property will at all times be held by the Trustee upon Trust for the Beneficiary who has provided all of the purchase moneys.

• The Beneficiary is and at all time has been absolutely entitled to the benefit of the Property together with all earnings, profits or gains accrued or to accrue in respect of the Property.

Together with your confirmation that all the income from assets acquired under the Loan Agreements will be reported as the Fund's income, the provisions in the Holding Trust Deed as mentioned above indicate that the parties intend the Fund to have a fixed entitlement to the income of the Holding Trusts. Therefore, to determine whether income derived by the Fund through the Holding Trusts is non-arm's length income of the Fund, consideration must be given to subsection 295-550(5) of the ITAA 1997.

If that conclusion was incorrect, income derived by the Fund as beneficiary of the Holding Trusts 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 (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 Full Federal Court in Allen 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.

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 Trustee holding, on behalf of the Fund, a fixed entitlement to the income of the Holding Trusts and any derivation of income by the Fund through the holding of that fixed entitlement. These steps include:

• the acquisition of the Property on behalf of the Fund;

• the establishment and operation of the Holding Trusts in favour of the Fund in respect of the Property acquired;

• the acquisition by the Fund of a fixed entitlement to the income of the Holding Trusts and the derivation of income by the Fund through holding that entitlement; and

• the establishment and operation of the LRBAs between the Fund Trustee and the Lender.

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 Holding Trusts 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, consideration is to be given to 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 court in numerous cases. In Federal Commissioner of Taxation v. AXA Asia Pacific Holdings Ltd (AXA) Justice Dowsett of the Full Federal Court summarised propositions from those cases 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 AXA 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': …

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' consists 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 both:

(a) the Loan Agreement between the Fund Trustee and the Lender; and

(b) the Holding Trusts in respect of any asset that may be acquired with money borrowed from the Lender and held on trust for the benefit of the Fund.

It is clear that the parties in this case are not in an arm's length relationship. This view is based on the fact that Member 1 and Member 2 are:

(a) the members of the Fund;

(b) the directors of the Fund Trustee;

(c) the directors of the Holding Trustee; and

(c) the Lender.

Consequently, as Dowsett J stated in AXA, it may be inferred that the dealing between the parties is not at arm's length. That being the case, it is necessary to consider whether the terms of the dealing between the parties can displace the inference based on the relationship of the parties.

Assessing the circumstances holistically, it is clear that the parties will not be dealing with each other in respect of the proposed arrangement 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.

• The full amount of the purchase price is to be lent. Typically, as the loan value ratio (LVR) is relevant to the lender limiting their loss, high LVR loans are generally provided where the risk of default and loss are small. To help mitigate the risk associated with high LVR, lenders will generally require additional terms such as mortgage insurance or an upfront risk fee (approximately 1.5% of the loan's value). In this case there is no mortgage insurance or upfront risk fee to be paid under the Loan Agreements.

• Rather than making regular periodic payments of the principal sum borrowed from the Lender, the Fund is only required to pay the principal sum borrowed at the end of the loan term, which ranges from 10 to 25 years. While some financial institutions do allow payment of the principal sum to be deferred for a number of years, periodic interest-only 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 interest-free loan re-paid by the borrowing party in a lump sum after a considerable period of time, as is in this case.

• No requirement by the Lender on the giving of personal guarantees by the members of the Fund as security for the Fund Trustee's performance under the Loan Agreements. If the Fund Trustee were to borrow from an independent lender, it could not reasonably expect to borrow the entire purchase price without providing security over the asset acquired with the borrowed money.

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 be expected to derive as a beneficiary of the Holding Trusts, would in the Commissioner's view, either be:

• 'nil' on the basis that:

• An independent (commercial) lender would not lend on the proposed terms and therefore, no income might be expected to be derived by the Fund through the Holding Trusts.

• If the Fund Trustee had to borrow from any other sources on commercial terms, the Fund Trustee would not be prepared to proceed with making additional investments on behalf of the Fund.

• 'less' on the basis that:

• Without being lent the amount by the Lender on the proposed terms, the Fund Trustee would have less funds to invest. In such a case it can reasonably be expected that, other things being equal, investments so made would generate a smaller income for the Holding Trusts and consequently, a smaller distribution to the Fund.

As the amount of income that the Fund will receive through holding a fixed entitlement to the income of the Holding Trusts 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 Holding Trusts will be non-arm's length income of the Fund under subsection 295-550(5) of the ITAA 1997.

Other relevant Comments

Whether income derived from property held on trust by Holding Trust is income of Holding Trust

We note that you have received legal advice that the Holding Trusts are Custodian Trusts (or bare trusts) and will not have net income.

The basic tax treatment of the net income of a trust estate is set out in Division 6 of Part III of the Income Tax Assessment Act 1936 (ITAA 1936) and applies to all trusts including bare trusts.

Confirmation of the Commissioner's view of how Division 6 applies to bare trust arrangements is set out in the Decision Impact Statement (DIS) for Colonial First State Investments Ltd v. Commissioner of Taxation. The DIS states that:

…

As set out above, the Commissioner's view is that so-called 'bare trusts' (including those referred to as nominee or custodian arrangements) are recognised for all income tax purposes (except pursuant to relevant CGT provisions and in cases materially the same as those in Colonial First State). Contrary to this view, the Commissioner understands that there is a current practice of essentially ignoring bare trusts for most income tax purposes, except in situations where the trustee has an obligation to withhold tax or is otherwise liable to pay tax in respect of a beneficiary (for example, pursuant to section 98 of the ITAA 1936).

Reform options to address this issue are currently being considered by Government (see the options paper released by the then Assistant Treasurer on 21 November 2011 Modernising the taxation of trust income - options for reform, in particular at sections 3.1 and 7.1).

Accordingly, and notwithstanding his view on this issue, the Commissioner will not generally seek to disturb the current practice (as described above) while these reform options are being considered. However, if the Commissioner is asked or required to state his view formally, then he will do so as he understands the law to operate (namely that Division 6 of Part III of the ITAA 1936 applies in determining who is taxed on the income of all bare trusts and in what amount - aside from cases with facts materially the same as those in Colonial First State). Examples of circumstances in which the Commissioner would be obliged to state and apply his view of the law as he understands it to operate include: the provision of a private or public ruling; putting arguments and submissions to the Tribunal or a Court in a litigation matter; and responding to issues raised at an ATO consultation forum, such as the National Tax Liaison Group (NTLG) or one of its Sub-groups. (Emphasis added).

Based on the above, irrespective of whether a Holding Trust is a bare trust, legal title to any asset held on trust by the Holding Trustee for the benefit of the Fund vests with the Holding Trustee and any income derived from that asset is income of the Holding Trust.

The Commissioner does not, therefore, agree with the view that a Holding Trust will not have net income.

Non-arm's length income - Legislative intent

The conclusion drawn 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, at [740] and [741], 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 at [740(2)] 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 into a concessionally taxed superannuation fund through a non-arm's length dealing from entities who would otherwise have to pay personal marginal tax rates on income that is derived from such capital, is clearly intended to be addressed by section 295-550 of the ITAA 1997 and its predecessors.

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