Edited version of your written advice

Authorisation Number: 1012851687606

Date of advice: 3 August 2015

Ruling

Subject: Non-arm's length income

Question

Will the provision of finance in the form of a loan agreement between the members of a superannuation fund and the superannuation fund give rise to non-arm's length income of the fund pursuant to subsection 295- 550(5) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Advice/Answer

No.

This ruling applies for the following period

Year ending 30 June 2016

The scheme commenced on

1 July 2015

Relevant facts and circumstances

The Fund is a complying self-managed superannuation fund.

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

The members of the Fund are the directors of the corporate trustee of the Fund.

The Fund's assets include Australian managed investments and Units in Australian unlisted unit trusts.

The members of the Fund own a commercial property (the Property).

The Fund will purchase the Property from the members of the Fund.

The part of the purchase price for the Property will be via vendor finance secured by second mortgage over the Property.

A letter from a financial institution outlines the terms of that they would charge in the scenario of the Fund borrowing in excess of the Standard Lending Value.

A loan agreement (the loan agreement) between the members of the Fund (the Lender), the trustee of the Fund and the Security Trustee (the Loan) outlines the terms of the Loan.

The Loan defines the Underlying Property as the Property, the loan amount and the term of the Loan.

You supplied a variation to the loan agreement.

Relevant legislative provisions

Income Tax Assessment Act 1936 Section 273

Income Tax Assessment Act 1936 Former subsection 273(7)

Income Tax Assessment Act 1997 Section 295-545

Income Tax Assessment Act 1997 Section 295-550

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

Reasons for decision

Summary

Any ordinary or statutory income derived by the Fund under the arrangement will not be non-arm's length income of the Fund.

Detailed reasoning

Explanation:

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) of the ITAA 1997 explains that a concessional rate of tax applies to the low tax component of the complying superannuation fund's taxable income, while the non-arm's length component is taxed at the highest marginal rate.

According to subsection 995-1(1) of the ITAA 1997, the phrase 'non-arm's length component' has the meaning given by section 295-545 of the ITAA 1997. 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. According to subsection 995-1(1) of the ITAA 1997, the phrase 'non-arm's length income' has the meaning given by section 295-550 of the ITAA 1997.

There are various subsections in section 295-550 of the ITAA 1997 under which amounts of ordinary income or statutory income of a complying superannuation fund are non-arm's length income of that fund. Subsections 295-550(4) and (5) of the ITAA 1997 specifically apply to such amounts derived as a beneficiary of a trust.

Subsection 295-550(4) of the ITAA 1997 provides that 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:

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.

Income derived as a beneficiary of a trust

Subsections 295-550(4) and (5) of the ITAA 1997 are relevant to the present case (and not subsection 295-550(1) of the ITAA 1997, which does not apply to amounts derived by a complying superannuation fund in the capacity of beneficiary of a trust) in relation to amounts included in the assessable income of the Fund that are sourced from the corporate trustee of the Fund's entitlement as the beneficiary of a trust. Such amounts are, for the purposes of those subsections, 'income derived by the [Fund] as a beneficiary of a trust.' (Allen v Federal Commissioner of Taxation (2011) 195 FCR 416; SSCASP Holdings Pty Ltd v Federal Commissioner of Taxation (2013) 211 FCR 332).

Fixed entitlement to income derived as a beneficiary of a trust

In paragraph 102 of Taxation Ruling TR 2006/7 Income tax: special income derived by a complying superannuation fund, complying approved deposit fund or pooled superannuation trust in relation to a year of income (TR 2006/7), the Commissioner sets out his view that a complying superannuation fund has a fixed entitlement to a trust distribution 'if the entity's entitlement to the distribution does not depend upon the exercise of the trustee's or any other person's discretion'.

Although that ruling is primarily concerned with the former section 273 of the Income Tax Assessment Act 1936 (ITAA 1936) - the immediate predecessor of section 295-550 of the ITAA 1997 -it is also taken to be a ruling about section 295-550 of the ITAA 1997 to the extent that it addresses issues in section 295-550 that are the same as were in the former section 273: see paragraphs 1A and 1C of that ruling, and section 357-85 in Schedule 1 to the Taxation Administration Act 1953 which provides that a ruling about a relevant provision (the 'old' provision) that is re-enacted or remade (the 'new' provision) is taken also to be a ruling about the new provision in so far as the new provision expresses the same ideas as the old provision. Indeed, the Commissioner has confirmed in his decision impact statement for The Trustee for the MH Ghali Superannuation Fund and Commissioner of Taxation [2012] AATA 527 that he will continue to apply the view expressed in paragraph 102 of TR 2006/7 for the purposes of subsections 295-550(4) and (5) of the ITAA 1997.

The Fund's entitlement to the income of the Security Trustee as the beneficiary of that trust does not depend upon the exercise of the Security Trustee's, or any other person's, discretion. Accordingly, it is the Commissioner's view that the Fund will derive ordinary or statutory income as a beneficiary of the Security Trustee through the holding of a fixed entitlement to the income of that trust.

Therefore, it is subsection 295-550(5), rather than subsection 295-550(4), of the ITAA 1997 that is to be considered further in the present case. If that view is wrong and instead the Fund derives ordinary or statutory income as a beneficiary of the Security Trustee, other than because of holding a fixed entitlement to the income of that trust, then that income will be non-arm's length income of the Fund pursuant to subsection 295-550(4) of the ITAA 1997.

Scheme

For subsection 295-550(5) of the ITAA 1997 to apply, there must be a scheme under which the Fund acquired its fixed entitlement to the income of a trust or under which an amount or amounts of ordinary or statutory income derived by the Fund as a beneficiary of a trust was or were so derived. 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 416 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 the ITAA 1936 in terms almost identical to a combination of the definitions of 'scheme' and 'arrangement' in the ITAA 1997. The court held, at 433-434, that the series of steps undertaken by Mr Allen in directing the trustees of several trusts (including the superannuation fund) led to the results that the superannuation fund received both a fixed interest in the relevant trust estate and the relevant distribution of income from that trust estate. The court also held that each result (that is, the fund's acquisition of its interest in the relevant trust estate and its derivation of income as a beneficiary of that trust) were readily seen to be the consequence of an 'arrangement' to which the various trustees were parties. Further, the court said that was 'clearly so, given that the creation of the structure and the flow of funds was orchestrated in conformity with the legal advice obtained by the taxpayers'.

The Full Federal Court's approach shows that, for the purposes of subsection 295-550(5) of the ITAA 1997, the scheme may be identified as including the circumstances under which the Fund:

• acquired its fixed entitlement to the income of a trust; and/or

• derived an amount or amounts of ordinary or statutory income as a beneficiary of the trust through holding that entitlement.

Similarly, for the purposes of applying subsection 295-550(5) of the ITAA 1997 in the present case, the scheme may be identified as involving the series of steps to be undertaken to give effect to the LRBA in conformity with the requirements of section 67A of the SISA. The scheme includes the establishment and operation of a loan and the Security Trustee. Those steps will result in the Fund acquiring its entitlement to the income of the Security Trustee through which entitlement the Fund will derive ordinary or statutory income as the beneficiary of that trust. Those results are readily seen to be the consequences 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 will acquire its fixed entitlement to the income of the Security Trustee under a scheme, and the ordinary or statutory income derived as the beneficiary of the Security Trustee through holding that entitlement will be derived under a scheme.

Parties to scheme not dealing at arm's length

The Commissioner considers that in the present case the parties are dealing with each other at arm's length in relation to the scheme.

The definition of 'arm's length' in 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 (2010) 189 FCR 204 at 213 (AXA) Dowsett J 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;

• 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 that case Edmonds and Gordon JJ, who did not disapprove of Dowsett J's summary of those propositions, further stated at 231 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 v Federal Commissioner of Taxation (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) - 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 income as beneficiary of a trust and any derivation of ordinary or statutory 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 LRBA (which includes the establishment and operation of a loan and the Security Trustee of which the Fund is the beneficiary).

It is clear that the parties in this case are not in an arm's length relationship. This is because the two individuals involved are:

• the only members of the Fund;

• the directors of the corporate trustee of the Fund (the borrower);

• the owners of the Property; and

• the Lenders.

Based on the above, the Commissioner considers that the requirements of paragraph 295-550(5)(a) of the ITAA 1997 are satisfied.

But have the parties, in respect of that dealing, dealt with each other as arm's length parties would do, so that the outcome of their dealing is a matter of real bargaining (or put another way, has the inference of non-arm's length dealing between non-arm's length parties that Dowsett J spoke about in AXA has been displaced)?

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 ordinary or statutory 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.

The Full Federal Court in Allen v Federal Commissioner of Taxation (2011) 195 FCR 416 at 429 observed, in relation to former paragraph 273(7)(b) of the ITAA 1936 - the immediate predecessor of paragraph 295-550(5)(b) of the ITAA 1997 - that this requires a comparison between a hypothetical arm's length dealing and what actually occurred. The Court also explained at the same page that the 'hypothetical situation' that the 'actual dealing' is to be compared with is that which 'might have been expected to apply if the parties to the arrangement had been dealing at arm's length.'

In this case, a letter from a financial institution outlines the terms of that they would charge in the scenario of the Fund borrowing in excess of the Standard Lending Value.

The loan agreement between the members of the Fund (the Lender), as trustee of the Fund and the Security Trustee (the Loan) sets out similar terms to those offered by the financial institution.

The above shows that the parties to the scheme in this case are dealing with each other at arm's length. An arm's length lender, the financial institution, would lend on similar terms for the acquisition of the Property.

The terms that the corporate trustee of the Fund have used to acquire the Property, is one into which arm's length parties would have entered.

Therefore, the Commissioner considers that the final requirement of subsection 295-550(5) of the ITAA 1997 is not satisfied. Therefore, any ordinary or statutory income derived by the Fund as beneficiary of the Security Trustee will not be non-arm's length income of the Fund.

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