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Ruling
Subject: Non-arm's length income - limited recourse borrowing arrangement
Question
If a self managed superannuation fund (the Fund) enters into a limited recourse borrowing arrangement with a related party and no interest is charged will this be a breach of the non-arm's length income provisions?
Answer
No
This ruling applies for the following period:
Income year ending 30 June 2013
The scheme commences on:
During the income year ending 30 June 2013
Relevant facts and circumstances
The Fund is a self managed superannuation fund (SMSF) with less than 5 members.
Member X and Member Y are aged under 65 and retired and Member Z is aged under 50.
During 2012-13 income year, the Fund purchased a commercial building (the Property).
The purchase of the Property was funded through a limited recourse borrowing arrangement established with the trustee of a trust (the Trust).
The purchase of the Property (including the stamp duty) was funded by a loan from a related party of the Fund (the Lender).
The loan term is for more than 10 years with an interest rate being set above the Reserve Bank of Australia Cash Rate.
The directors of the Lender are Member X and Member Y.
The Property is rented to an unrelated party at the commercial rate of rent.
The Lender is willing to reduce the interest rate charged to nil in order to take the pressure off the Fund having to find cash to fund future minimum pension payment increases.
Relevant legislative provisions
Income Tax Assessment Act 1997 Section 6-5
Income Tax Assessment Act 1997 Section 6-10
Income Tax Assessment Act 1997 Section 4-15
Income Tax Assessment Act 1997 Subsection 295-550(1)
Reasons for decision
Summary
The income derived by the Fund on the limited recourse borrowing arrangement will not be non-arm's length income of the Fund if the Lender, who is a related party of the Fund, reduces the interest due on a loan to 0%.
Detailed reasoning
Subsection 295-550(1) of the ITAA 1997 lists the types of ordinary income or statutory income that are non-arm's length income of a complying superannuation fund and, as far as relevant, states:
An amount of ordinary income or statutory income is non-arm's length income of a complying superannuation fund, a complying approved deposit fund or a pooled superannuation trust (other than an amount to which subsection (2) applies or an amount derived by the entity in the capacity of beneficiary of a trust) if:
(a) it is derived from a scheme the parties to which were not dealing with each other at arm's length in relation to the scheme; and
(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…
Subsection 295-550(1) of the ITAA 1997 applies only to amounts of ordinary income (section 6-5 of the ITAA 1997) or statutory income (section 6-10 of the ITAA 1997). It does not capture taxable income (section 4-15 of the ITAA 1997), that is, the subsection does not require the consideration of the overall economic benefit obtained from the scheme.
Therefore, for subsection 295-550(1) of the ITAA 1997 to apply, the scheme must inflate the level of ordinary or statutory income derived as a result of the non-arm's length dealings. Whether or not the level of taxable income derived by the entity is inflated as a result of a lower level of deduction amounts than would normally be incurred had the parties been dealing at arms length is not to be taken into account in applying subsection 295-550(1) of the ITAA 1997.
In this case, the Fund will derive a greater level of taxable income because the rate of interest payable by the fund is reduced to 0%. That is, the level of taxable income derived by the Fund will be inflated as a result of a lower level of deduction amounts than would normally be incurred if the parties were dealing at arm's length. However, subsection 295-550(1) of the ITAA 1997 does not apply in these circumstances as this subsection applies strictly to amounts of ordinary or statutory income, not taxable income.
Therefore, the income derived by the Fund in these circumstances is not non-arm's length income of the Fund as defined in subsection 295-550(1) of the ITAA 1997.