Edited version of private advice

Authorisation Number: 1012623016073

Ruling

Subject: Non-arm's length income and limited recourse borrowing arrangement

Questions

1. If a related party, who is the sole member of the Fund, lends to the Fund under a limited recourse borrowing arrangement (LRBA) at a zero rate of interest would the discount of interest to the market rates be considered a contribution to the Fund over the term of the loan?

2. If the Fund enters into the LRBA with the related party and no interest is charged over the term will this give rise to non-arm's length income?

Advice/Answers

1. No.

2. 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 self-managed superannuation fund with one member.

The Member is the sole director of the corporate trustee of the Fund.

The Member is over 55 years old and their balance in the Fund is in accumulation mode.

In the 2013-14 income year the Fund purchased a commercial property (the Property).

The Property settled in in the 2013-14 income year.

The Fund intends to purchase the Property on trust under a limited recourse borrowing arrangement where an amount is borrowed from the Member. The remaining purchase price and costs will be funded from the existing fund assets.

The borrowing will be governed under a formal loan agreement over an agreed term with a zero rate of interest and quarterly repayments.

The Property is a single acquirable asset, is a permitted acquisition under the investment restrictions governing superannuation and was acquired from an unrelated party at public auction.

The Property is a new building and part of an urban renewal project.

The Property will be leased for an agreed term.

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 lower rate of interest is not something of value that increases the capital of the Fund and will not be treated as a contribution to the Fund.

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

Detailed reasoning

Superannuation contribution

The Income Tax Assessment Act 1997 (ITAA 1997) does not define the term 'contribution'. According to The Macquarie Dictionary 3rd edition 1998. The ordinary meaning of 'contribution' is:

1. the act of contributing;

2. something contributed.

The ordinary meaning of 'contribute' is:

1. ... give [money, time etc.] to a common stock or for a common purpose';

...

3 to make contribution; furnish a contribution'.

In Taxation Ruling 2010/1 entitled Income tax: superannuation contributions (TR 2010/1) the Commissioner has given his view on what would constitute 'contributions' to superannuation funds and the reasons for taking such a view. Paragraph 4 of TR 2010/1 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.

Further, paragraph 108 of TR 2010/1 provides:

Consistent with basic principles of statutory interpretation, it is necessary to ascertain the meaning of a 'contribution' to a superannuation fund having regard to the context and underlying purpose of the legislative provisions in which the term appears. An analysis of the statutory context, in particular the scheme of the ITAA 1997 and related superannuation legislation, will help determine whether the legislation intends to adopt the ordinary meaning of 'contribution'.

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.

In general terms, the Commissioner considers that the matter of whether an amount is a superannuation contribution is determined by having regard to whether a superannuation provider is given something of value and whether what is given is given for a particular purpose.

As mentioned above, the Commissioner considers that 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.

As such, it is clearly appropriate to consider the natural and probable consequences of a transaction or arrangement to determine whether a contribution has been made.

In this case the Fund entered into a limited recourse borrowing arrangement (LRBA) with a related party, who is the sole member of the Fund at a zero rate of interest charged over the term of the agreement.

The lower rate of interest is not something of value that increases the capital of the Fund. On this basis the Commissioner has come to the view that the zero rate of interest will not be treated as a contribution to the Fund.

Non-arm's length income

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.

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 of the ITAA 1997. Subsection 295-550(1) of the ITAA 1997 provides that:

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.

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 (AXA) (2010) 189 FCR 204 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;

• un-related 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 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': …

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 with one member (the Member). The Member is the sole director of the corporate trustee of the Fund. The Fund intends to purchase the Property on trust under a limited recourse borrowing arrangement an amount is borrowed from the Member.

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:

• the lender is not, by way of charging a zero rate of interest under the loan, compensated adequately for the risk assumed in relation to recovery of the principal in the event of the borrower's default;

• no security required by the lender for the loan; and

• the absence of protection mechanisms given the limited recourse nature of the loan, lack of other security, and the risk involved in investing in the Property.

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:

• pay a higher level of interest reflective of the risk faced by the lender; and/or

• require security for the loan arrangement.

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:

"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 s 273, 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 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 '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 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.