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Edited version of your written advice

Authorisation Number: 1012674694054

Ruling

Subject: Limited recourse borrowing arrangement and non-arm's length income

Question

If the self-managed superannuation fund enters into a limited recourse borrowing arrangement at a below market value rate of interest or zero rate of interest will this give rise to non-arm's length income?

Advice/Answers

Yes.

This ruling applies for the following period

Year ending 30 June 2014

The scheme commenced on

1 July 2013

Relevant facts and circumstances

The Fund is a complying self-managed superannuation fund.

The Fund was established in the late 1990s.

The members of the Fund (the Members) are married to each other.

The corporate trustee of the Fund (the Fund Trustee), was incorporated and became the trustee of the Fund in the 2013-14 income year.

The Members are the directors of the Fund Trustee.

The Fund purchased freehold property (the Property). The Property is used in a business and was acquired from an unrelated party. The Members have acquired the business in their own names and will be conducting the business through a partnership (the Partnership) of which they are partners.

As part of the purchase, a lease agreement for the rental of the freehold was assigned across to the Fund (as lessor) and the Partnership (as lessee). This lease agreement expires in the 2015-16 income year. As per the lease agreement, the rent is reviewed on each anniversary of the commencement date. The rent review method selected was the consumer price index (CPI) method. The Members have sought confirmation that the current level of leasing income is an appropriate market value level.

In a Letter of Agents Opinion of Value a real estate agent has given an estimate of the value of the land and buildings together with an estimate of the value of a reasonable rent.

In the 2013-14 income year a limited course borrowing arrangement (the Loan Agreement) for the Property was entered into between:

A holding company will hold the Property in a bare trust for the Fund. The Members are the directors of the holding company.

The Fund Trustee has currently borrowed an amount for a term of over 10 years. The term of the loan may be varied with the consent of both the Lender and the Borrower. The initial interest rate is variable and payable in arrears. The loan is interest only for the first few years with the ability by the Fund to make capital repayments during this time.

The Members have agreed to advance and the Fund has agreed to borrow and accept a maximum amount not exceeding a predetermined facility amount subject to the terms and conditions of the Loan Agreement. The Fund may draw down amounts up to the facility amount subject to the money being applied for the acquisition, maintenance or repair of the Property. There may be multiple drawdowns and they may occur over a period of time. Further, the Members as the lender may increase the facility amount at its discretion.

The Members rights as lenders against the Fund as the borrower in respect of the loan are limited to rights relating to the asset only. The lender may take a mortgage, charge or any type of security over the asset. The lender confirms that the total amount outstanding is not otherwise secured by or against the borrower.

The Members are currently considering varying the terms of the interest payable under the loan to either a below market value rate of interest or zero rate of interest.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 295-550.

Income Tax Assessment Act 1997 Section 295-545.

Income Tax Assessment Act 1997 Subsection 995-1(1).

Further issues for you to consider

Not applicable.

Anti-avoidance rules

Not applicable.

Reasons for decision

Summary

The discount of interest to the market rates will be non-arm's length income of the Fund.

Detailed reasoning

Non-arm's length income

Section 295-545 of the Income Tax Assessment Act 1997 (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.

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. The phrase 'non-arm's length income' has the meaning given by section 295-550. Subsection 295-550(1) provides that:

(b) that amount 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 relation to 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.

In Federal Commissioner of Taxation v AXA Asia Pacific Holdings Ltd Justice Dowsett of the Full Federal Court 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 that case Justices Edmonds and Gordon further stated that:

It is clear that the parties in this case are not in an arm's length relationship.

The Fund is a self-managed superannuation fund and the members of the Fund are married to each other.

The Fund purchased the Property from an unrelated party. As noted earlier, the Members have acquired the business in their own names and will be conducting the business using the Property through a partnership (the Partnership) of which they are equal partners.

As part of the purchase, a lease agreement for the rental of the Property was assigned across to the Fund (as lessor) and the Partnership (as lessee).

In the 2013-14 income year a limited course borrowing arrangement for the Property was entered into between the Members (the Lender) and the Fund Trustee (the Borrower).

The Property will be held in a bare trust for the Fund. The Members are the directors of the bare trustee.

The Fund Trustee has currently borrowed an amount for a term in excess of 10 years. The term of the loan may be varied with the consent of both the Lender and the Borrower. The initial interest rate is variable and payable in arrears. The loan is interest only for the first few years with the ability to make capital repayments during this time.

The Members have agreed to advance and the Fund has agreed to borrow and accept a maximum amount not exceeding a predetermined facility amount subject to the terms and conditions of the Loan Agreement. The Fund may draw down amounts up to the facility amount subject to the money being applied for the acquisition, maintenance or repair of the Property as contemplated by section 67(1)(a) of the SIS Act. There may be multiple drawdowns and they may occur over a period of time. Further, the Members as the lender may increase the facility amount at its discretion.

The Members rights as lenders against the Fund as the borrower in respect of the loan are limited to rights relating to the asset only. The lender may take a mortgage, charge or any type of security over the asset. The lender confirms that the total amount outstanding is not otherwise secured by or against the borrower.

The Members are currently considering varying the terms of the interest payable under the loan to either a below market value rate of interest or a zero rate of interest.

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

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

The final requirement is that the amount 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 Fund might be expected to:

Conclusion

As such, the discount of interest to the market rates will be non-arm's length income of the Fund pursuant to subsection 295-550(5) of the ITAA 1997.

Legislative intent

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

Section 295-550's earliest predecessor - former section 23F of the ITAA 1936 - was introduced in 1964 as a result of the Report of the Commonwealth Committee on Taxation, 1961 (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:

Further, the Full Federal Court in Darrelen Pty Ltd v Federal Commissioner of Taxation stated that:

Similarly, the Explanatory Memorandum accompanying the Bill 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 that:

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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