Edited version of your written advice

Authorisation Number: 1051314043854

Date of advice: 18 December 2017

Ruling

Subject: Non-arm’s length income

Question 1

Will any ordinary or statutory income derived by the trustees of a complying a self-managed superannuation fund (the Fund) from its holding of units in an unlisted unit trust (the Unit Trust) be considered non-arm’s length income (NALI) for the purposes of subsection 295-550 of the Income Tax Assessment Act 1997?( ITAA 1997).

Answer

Yes

Question 2

Will the taxable income of the Fund include a non-arm’s length component for the purposes of section 295-545 of the ITAA 1997 as a result of the Fund’s holding of units in the Unit Trust?

Answer

Yes

This ruling applies for the following period:

Income year ended 30 June 201Y

Income year ending 30 June 201Z

The scheme commences on:

1 July 201X

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

The Fund has two members (Member 1 and Member 2).

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

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

Member 1 is the sole director and shareholder of the trustee of the Unit Trust.

The Fund intends to acquire units (the Units) in the Unit Trust.

The Fund Trustee intends to borrow a portion of the purchase price from Member 1 and the balance of the purchase price will be sourced from the Fund’s own monies.

The purchase of the Units will be financed through a limited recourse borrowing arrangement (LRBA) between the Fund Trustee (as the Borrower) and Member 1 (as the Lender).

The Units will be held on trust by the trustee of an instalment trust (the Instalment Trustee).

The trustee of the Instalment Trust is Member 1.

A draft loan agreement (the Loan Agreement) made between Member 1 (as the Lender), the Fund Trustee (as the Borrower) and Member 2 (as the Guarantor) contains the following relevant clauses:

● Initial loan amount is a specified amount.

● Maturity date is 15 years from the draw down date.

● The loan plus any interest or further amounts outstanding will be repaid by the Fund Trustee to the Lender on receipt by the Lender from the Fund Trustee of a notice, or on the maturity date, whichever is the earlier, in which the Fund Trustee elects to either:

● repay the loan (or part of the loan) by making a completion payment and any other fees, costs and disbursements; or

● cause the Lender to sell the underlying units to repay the loan (or part of the loan).

● The Lender and the Fund Trustee may agree to the interest rate being fixed for a period not exceeding 5 years from draw down date.

● Interest and principal payments are to be made in advance on a monthly basis.

● Interest rate will be the Reserve Bank of Australia indicator lending rates for banks supplying standard variable housing loans for investors as published for the month of May immediately prior to the start of the relevant financial year.

● For the purposes of securing payment of the loan and any interest payable according to the terms of the Loan Agreement, the Lender will hold title over the underlying units.

● The Guarantor has requested that the Lender provide the loan to the Fund Trustee and the Lender has agreed to do so in consideration of this guarantee.

● The Lender’s rights with respect to the loan (including any interest and any other costs/amounts) are limited to the underlying units.

● The Guarantor guarantees the repayment of the loan and the interest.

A draft copy of the Instalment Trust deed (the Instalment Trust Deed) made between the Fund Trustee and Member 1 as the Lender contains the following relevant clauses:

● The Lender will obtain the legal title in the underlying units and will either directly hold (or appoint a nominee to hold) the underlying units.

● The underlying units are to be held under a bare trust relationship by the Lender.

● The Fund Trustee will hold a beneficial interest in the underlying units at all times.

● The Lender acknowledges that the legal title in the underlying units is to remain with the Lender until the loan from the Fund Trustee to the Lender is fully repaid.

● The arrangements and relationships as between the Lender and the Fund Trustee with respect to the underlying units are intended to fall within the scope of section 67A of the SISA.

A draft copy of the Unit Trust deed (the Unit Trust Deed) contains the following relevant clauses:

● When the trustee determines to pay the net income, the trustee must pay the net income to the members in accordance with their respective member proportion.

● Member proportion means with respect to the units or to each class of units, the proportion of those units issued that are held by the member.

● The members are presently entitled to both the income and the capital of the trust. This clause is irrevocable and cannot be removed, restricted or otherwise affected by any discretion, or the failure to exercise discretion by anyone, including the trustee, under the terms of the Unit Trust Deed.

Relevant legislative provisions

Income Tax Assessment Act 1936 Former subsection 273(7)

Income Tax Assessment Act 1936 Former paragraph 273(7)(a)

Income Tax Assessment Act 1997 Subdivision 235-I

Income Tax Assessment Act 1997 Section 235-820

Income Tax Assessment Act 1997 Section 295-545

Income Tax Assessment Act 1997 Subsection 295-545(1)

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(1)

Income Tax Assessment Act 1997 Paragraph 295-550(1)(a)

Income Tax Assessment Act 1997 Paragraph 295-550(1)(b)

Income Tax Assessment Act 1997 Subsection 295-550(4)

Income Tax Assessment Act 1997 Subsection 295-550(5)

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

Taxation Administration Act 1953 Section 357-85 of Schedule 1

Superannuation Industry (Supervision) Act 1993 Section 67A

Reasons for decision

Summary

Based on the facts, it is considered that any income derived by the Fund in the capacity of a beneficiary of the Unit Trust will be NALI in accordance with subsection 295-550(5) of the ITAA 1997.

Accordingly, the taxable income of the Fund will include a non-arm’s length component for the purposes of section 295-545 of the ITAA 1997.

Detailed reasoning

Non-arm’s length income

Subsection 295-545(1) 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 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.

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 income derived by a complying superannuation fund as a beneficiary of a trust.

As a result of the application of Subdivision 235-I of the ITAA 1997, a regulated superannuation fund that invests in an asset through an LRBA is treated for most income tax purposes as if it had invested in the asset directly.

Therefore, in this case, for tax purposes, the Fund will be considered to have invested in the units in the Unit Trust directly and therefore will derive income from that investment in the capacity of beneficiary of the Unit Trust.

Income 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 provides:

Other income *derived by the entity as a beneficiary of a trust through holding a fixed entitlement to the income of the trust in 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.

*To find definitions of asterisked terms, see the Dictionary, starting at section 995-1.

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 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 TR 2006/7, 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 views expressed in TR 2006/7 for the purposes of section 295-550 of the ITAA 1997.

It is clear from the terms of the Unit Trust Deed that the Fund's entitlement to the income and capital of the Unit Trust does not depend upon the exercise of the Unit Trust trustee's, or any other person's, discretion. When the trustee determines to pay the net income, the Trustee is required to pay the net Income to the members in accordance with their respective member proportion.

Accordingly, it is the Commissioner's view that the Fund will derive ordinary or statutory income as a beneficiary of the Unit Trust 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 applies in this case. If that view is incorrect and instead the Fund derives income as a beneficiary of the Unit Trust, other than because of holding a fixed entitlement to the income of that trust, then that income will be NALI 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 ordinary or statutory income was so derived by the Fund. 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.

*To find definitions of asterisked terms, see the Dictionary, starting at section 995-1.

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 (Allen) 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 former subsection 273(7) of the ITAA 1936, the scheme may be identified as including the circumstances under which the Fund:

● acquired its fixed entitlement to the income of the Unit Trust; and/or

● derived an amount or amounts of ordinary or statutory income as a beneficiary of the Unit Trust through holding that entitlement.

Similarly, for the purposes of applying subsection 295-550(5) of the ITAA 1997 in this 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 the loan and the Instalment Trust. Those steps will result in the Fund Trustee acquiring its beneficial interest in the asset acquired under the LRBA through the Instalment Trust which by virtue of section 235-820 of the ITAA 1997 results in the Fund deriving ordinary or statutory income from the asset held by the Instalment Trust, as the Fund Trustee is treated as the owner of the asset.

As such, it is concluded that, for the purposes of paragraph 295-550(5)(a) of the ITAA 1997, the Fund will acquire its entitlement to the income, and will derive income under a scheme.

Parties to scheme not dealing at arm's length

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 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 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.

A similar approach in this case means that for the purposes of applying paragraph 295-550(5)(a) of the ITAA 1997, regard may be had to the establishment and operation of the LRBA which includes the establishment and operation of the loan and the Instalment Trust.

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 Fund Trustee (the borrower);

● the trustee of the Instalment Trust (Member 1);

● the Lender (Member 1); and

● the Guarantor (Member 2).

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 been displaced)?

Assessing the scheme based on the facts and evidence provided, the Commissioner considers that the parties will not be dealing with each other in relation to the scheme as arm's length parties would do.

Although the terms adopted for the LRBA might meet the requirements set out in the Practical Compliance Guidelines PCG 2016/5 Income tax - arm’s length terms for Limited Recourse Borrowing Arrangements established by self managed superannuation funds (PCG 2016/5) which sets out the ‘Safe Harbour’ terms on which SMSF trustees may structure their LRBAs consistent with an arm’s length dealing, adopting these terms for a loan to purchase units in an unlisted unit trust is not sufficient evidence that the borrowing has been made on arm’s length terms because PCG 2016/5 applies where asset acquired is real property or a collection of stock exchange listed shares or units, and does not apply to units in an unlisted unit trust.

Therefore, in the absence of evidence that an LRB could be established and maintained on terms that are consistent with the terms of a commercial loan that is available in the same circumstances, the Commissioner considers that the parties would not be dealing with each other at arm’s length in relation to negotiating and maintaining the loan, and accordingly the requirements of paragraph 295-550(5)(a) of the ITAA 1997 have been met.

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 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.

TD 2016/16 Taxation Determination - Income tax : will the ordinary or statutory income of a self-managed superannuation fund be non-arm’s length income under subsection 295-550(1) of the Income Tax Assessment Act 1997 (ITAA 1997) when the parties to a scheme have entered into a limited recourse borrowing arrangement on terms which are not at arm’s length? (TD 2016/16) states that paragraph 295-550(1)(b) of the ITAA 1997 requires a determination of the amount of ordinary or statutory income that a Fund Trustee might have been expected to derive if the same parties to the scheme had been dealing with each other on an arm's length basis under each step of the scheme.

Whilst TD 2016/16 sets out the Commissioner’s interpretation of paragraph 295-550(1)(b) of the ITAA 1997, paragraph 295-550(5)(b) expresses substantively identical principles for income derived through holding a fixed entitlement to income of a trust, and therefore the same test applies. Paragraph 3 of TD 2016/16 states that it is necessary to identify what the terms of the borrowing arrangement may have been if the parties were dealing with each other at arm’s length (hypothetical borrowing arrangement). Paragraph 4 states that having identified a hypothetical borrowing arrangement the terms of which are on an arm's length basis, it is then necessary to establish whether it is reasonable to conclude that the Fund Trustee could have and would have entered into the hypothetical borrowing arrangement.

In this case, no evidence has been presented which identifies what the terms of a hypothetical borrowing arrangement would be if the parties were dealing with each other at arm’s length.

In the absence of such evidence, no hypothetical borrowing arrangement can be identified. Consequently, the Commissioner concludes that the Fund Trustee could not and would not have entered into such a hypothetical borrowing arrangement, as none exists.

Therefore, the Commissioner considers that the Fund will derive more income from the scheme than it might be expected to derive if the parties had been dealing with each other at arm’s length.

Accordingly the Commissioner considers that paragraph 295-550(5)(b) of the ITAA 1997 is satisfied.

As all the conditions of subsection 295-550(5) of the ITAA 1997 have been met, any income derived by the Fund in its capacity as beneficiary of the Unit Trust will be considered non-arm’s length income for the purposes of subsection 295-550(5) of the ITAA 1997, and the taxable income of the Fund will include a non-arm’s length component for the purposes of section 295-545 of the ITAA 1997.

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