Edited version of private advice

Authorisation Number: 1012634565634

Ruling

Subject: Limited recourse borrowing arrangement

Issue 1

Questions

Will loan arrangements between the Fund and a related party of the Fund breach section 109 of the Superannuation Industry (Supervision) Act 1993 (SISA) if a zero interest rate is charged on the borrowing?

Advice

The Commissioner declines to rule

Issue 2

Questions

1. Will the outstanding interest component on the loans be treated as a contribution to the Fund?

2. Will the loan arrangements give rise to non-arm's length income of the Fund?

Answers

No.

Yes.

Issue 3

Question

Will the provision of the loans with a zero rate of interest be regarded as a scheme for the purposes of Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936)?

Answer

The Commissioner has not yet ruled.

This ruling applies for the following period:

Year ending 30 June 2014

The scheme commences on:

During the income year ending 30 June 2014

Relevant facts and circumstances

The Fund is a regulated self-managed superannuation fund (SMSF).

The Fund is a single member fund.

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

The only director and shareholder of the Fund Trustee is the Fund member (the Member).

The Fund Trustee intends to purchase, on behalf of the Fund, shares in the Banking industry. The shares will be purchased directly from the share market.

The purchase of shares will be financed by the Member through a number of limited recourse borrowing arrangements (LRBAs). The amount to be borrowed is a specific amount.

Separate LRBAs will be established for each batch of identical shares. The terms of the LRBAs will be set out in separate but identical loan agreements (the Loan Agreements).

The Loan Agreements will include the following terms:

• the term of the loan is several years;

• no principle payments are required for a first few years with voluntary payments allowed at any time; and

• the interest rate is 0%.

Each batch of shares will be held in a separate bare trust (the Holding Trust).

The trustee of the all the Holding Trusts (the Holding Trustee) is a private company.

The only director and shareholder of the Holding Trustee is the Member.

Each Holding Trust is established under an identical Holding Trust Deed of Establishment (the Holding Trust Deed).

The Member wants to increase the assets held in the Fund for the purpose of asset protection and succession planning. The Member is a single parent who wants to ensure that their sole beneficiary will inherit their estate. The Member wants to ensure that the beneficiary is able to fund their own lifestyle and not have access to the Fund during their working life.

The Member has no specific need for income from the loans and wants to ensure the funds are safely protected and given the best chance to grow. The Member views the payment of interest as unnecessary.

The Fund does not intend to pay a pension to the Member.

Relevant legislative provisions

Reasons for decision

Summary

This issue relates to the provisions contained in the SISA and the Superannuation Industry (Supervision) Regulations 1994 (SISR). As such, it is not a relevant provision for the purposes of section 357-55 of Schedule 1 to the Taxation Administration Act 1953 (TAA). Consequently, the Commissioner cannot make a private ruling on this issue.

Detailed Reasoning

In accordance with subsection 359-5(1) of Schedule 1 to the TAA, the Commissioner may, on application, make a written private ruling on the way in which the Commissioner considers a relevant provision applies, or would apply, to an entity in relation to a specified scheme.

Section 357-55 of Schedule 1 to the TAA states that provisions of Acts and regulations of which the Commissioner has the general administration are relevant for rulings if they are about any of the following:

(a) benefits tax;

(b) franking tax;

(c) withholding tax;

(d) Medicare levy;

(e) fringe tax;

(f) mining withholding tax;

(faa) MRRT

(fa) petroleum resource rent tax;

(fb) indirect tax;

(fc) excise duty;

(g) the administration or collection of those taxes, levies and duties;

(h) a grant or benefit mentioned in section 8 of the Product Grants and Benefits Administration Act 2000, or the administration or payment of such a grant or benefit; withholding;

(i) a net fuel amount, or the administration a net fuel amount;

(ia) an assessed net fuel amount, or the collection or payment of an assessed net fuel amount

(j) a net amount, or the administration, collection or payment of a net amount;

(ja) an assessed net amount, or the collection or payment of an assessed net amount

(k) a wine tax credit, or the administration or payment of a wine tax credit.

In your application for a private ruling, we have identified a number of issues on which you ask the Commissioner to make a private ruling. One of these issues is in relation to certain provisions contained in the SISA and the SISR.

However, because the Commissioner does not have the general administration of the SISA and the SISR, these issues do not relate to provisions that are the relevant provisions for the purposes of section 357-55 of Schedule 1 to the TAA. Therefore, the Commissioner cannot make a private ruling on this particular issue.

While the Commissioner cannot make a private ruling on this particular issue, the Commissioner can provide SMSF specific advice instead.

SMSF specific advice applies to a specific transaction or arrangement that has been or might be entered into by the trustees of an SMSF. It is based on the facts of the specific transaction or arrangement defined in the trustees' application.

Accordingly, we provide the following SMSF specific advice for Issue 1 of your application

Self-Managed Superannuation Fund specific advice

Summary

Neither the SISA nor the Income Tax Assessment Act 1997 (ITAA 1997) prohibit the Fund from entering into limited recourse borrowing arrangements (LRBAs) with the related party of the Fund only because a zero rate of interest is charged over the term of the borrowings in accordance with the Loan Agreements.

Detailed reasoning

Arm's length dealing with other parties

Subsection 109(1) of the SISA imposes requirements with respect to investments made by a trustee of a superannuation fund. It provides that the trustee (or investment manager) must not invest in that capacity unless the trustee and the other party to the relevant transaction are dealing with each other at arm's length in respect of the transaction, or:

(b) both:

(i) the trustee or investment manager, as the case may be, and the other party to the relevant transaction are not dealing with each other at arm's length in respect of the transaction; and

(ii) the terms and conditions of the transaction are no more favourable to the other party than those which it is reasonable to expect would apply if the trustee or investment manager, as the case may be, were dealing with the other party at arm's length in the same circumstances.

Whether the trustee of a regulated superannuation fund contravenes section 109 of the SISA if they enter into an LRBA with a related party of the fund on terms that are more favourable to the fund than arm's length terms, has been considered in the ATO Interpretative Decision ATO ID 2010/162.

As discussed in ATO ID 2010/162, the term 'invest' is defined in subsection 10(1) of the SISA to mean:

(a) apply assets in any way; or

(b) make a contract;

for the purpose of gaining interest, income, profit or gain.

When entering into an LRBA, the trustee of a superannuation fund is entering into a contract for the purpose of gaining an interest in the property which is subject of the LRBA, together with any income, profit or capital gain in respect of that property. That is, in accordance with subsection 10(1) of the SISA, the trustee is making an investment.

In this case, the fact that LRBAs are interest free is more favourable to the Fund rather than the related party lender. Therefore, based on the above, the fact that the LRBAs are on interest-free terms does not cause a contravention of section 109 of the SISA as that fact does not make the terms and conditions of the borrowing more favorable to the related party (the Member) than would be reasonably expected if the parties were dealing with each other at arm's length in the same circumstances.

Further, section 67A of the SISA is an exception to the borrowing rules set out in section 67 of the SISA which prohibits trustees of regulated superannuation funds from borrowing money, or maintaining an existing borrowing of money, except in specific circumstances. The meaning of 'borrow' for the purposes of section 67 is explained in Self Managed Superannuation Fund Ruling SMSFR 2009/2 (SMSFR 2009/2) which, at paragraph 10, states:

… for the purposes of section 67, a borrowing is an arrangement that exhibits two necessary characteristics:

• a temporary transfer of an amount of money from one entity (the lender) to another (the borrower); and

• an obligation or an intention on the part of the borrower to repay that amount to the lender (which may be satisfied by the provision of an asset).

Paragraph 48 of the SMSFR 2009/2 states that, while an obligation to pay interest may evidence the existence of a borrowing of money, it is not a necessary feature of such a borrowing.

Therefore, the absence of a requirement to pay interest on money loaned to the Fund by the Member will not prevent the LRBAs from being a borrowing for the purposes of section 67A of the SISA.

Please note:

While similar in form to a tax private ruling, the above SMSF specific advice is not binding on the Commissioner and does not have the same review rights as a private ruling.

Issue 2

Summary

The fact that there is no obligation on the part of the Fund to pay interest on the borrowings under the Loan Agreements does not result in an increase in the capital of the Fund. Therefore the discounted amount of interest (that is, the difference between the market rate of interest and 0% interest rate) is not considered to be a superannuation contribution received by the Fund.

If the Fund enters into various LRBAs on the terms of the Loan Agreements, income derived by the Fund through the Holding Trusts will be non-arm's length income of the Fund.

Detailed reasoning

Superannuation contribution

The ITAA 1997 does not define the term 'contribution'. Therefore, consistent with basic principles of statutory interpretation, the term 'contribution' is to be given its ordinary meaning having regard to the context and underlying purpose of the legislative provisions in which the term appears.

In Taxation Ruling 2010/1 (TR 2010/1) the Commissioner gives 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.

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.

Where, as here, an arrangement is put in place to ensure that a superannuation fund does not incur a liability to meet certain expenses, as illustrated by the examples in paragraphs 75; 76; 81 and 82 of TR 2010/1, there is no increase in the capital of the superannuation fund and no contribution is made to the superannuation fund under the arrangement.

In this case, the Fund intends to enter into a number of LRBAs in accordance with the terms of the Loan Agreements which ensure that the Fund does not incur a liability for an interest expense during the term of the borrowings.

Based on the above, the fact that there is no liability on the part of the Fund to pay interest on the borrowings under the Loan Agreements does not result in an increase in the capital of the Fund. On that basis, the Commissioner has come to the view that the discounted amount of interest (that is, the difference between the market rate of interest and 0% interest rate) is not considered to be a superannuation contribution received by the Fund.

Meaning of 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. The note to subsection 295-545(1) explains that a concessional rate of tax applies to the low tax component, while the non-arm's length component is taxed at the highest marginal rate. These rates are set out in the Income Tax Rates Act 1986.

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.

Amounts of ordinary income or statutory income of a superannuation fund that are non-arm's length income of a fund are set out in section 295-550 of the ITAA 1997. Relevantly, income that is derived by a fund as a beneficiary of a trust is dealt with in subsections 295-550(4) and (5) of the ITAA 1997.

Subsection 295-550(4) of the ITAA 1997 covers income derived by a complying superannuation fund through a trust by way of holding other than a fixed entitlement to the income of the trust. Subsection 295-550(5) of the ITAA 1997 covers income derived by the fund through a trust by way of holding a fixed entitlement to the income of the trust.

Fixed entitlement to trust income

Taxation Ruling TR 2006/7 explains what amounts are considered to be 'special income' under former section 273 of the ITAA 1936 which was repealed with effect from 1 July 2007. Former section 273 has been re-written, with some modifications, in section 295-550 of the ITAA 1997. To the extent that section 295-550 of the ITAA 1997 expresses the same ideas as former section 273, TR 2006/7 is also taken to be a ruling about section 295-550 of the ITAA 1997.

In accordance with paragraph 101 of TR 2006/7, if a complying superannuation fund derives income from a trust by way of the trustee or any other person exercising a discretion, the income distributed will be non-arm's length income of the fund under subsection 295-550(4) of the ITAA 1997.

A trust distribution to a complying superannuation fund will fall within subsection 295-550(5) of the ITAA 1997 rather than subsection 295-550(4) of the ITAA 1997 only if the fund's entitlement to the distribution does not depend upon the exercise of the trustee's, or any other person's discretion, that is, if the fund holds a fixed entitlement to the income of the trust.

In all cases, the determining factor in deciding if a fixed entitlement exists is the terms of the trust instrument under which the trust is constituted. In this case, that is the Holding Trust Deed.

Relevantly, the Holding Trust Deeds state:

The Trustee undertakes to deal with the Property and exercise and perform all the rights, duties and powers relating to the Property only as directed by the Beneficiary.

The Beneficiary is and at all time has been absolutely entitled to the benefit of the Property together with all earnings, profits or gains accrued or to accrue in respect of the Property.

Beneficiary is the trustee of the SMSF who is absolutely entitled to Property held on Holding Trust by the Trustee.

Property includes the Property subject of the Holding Trust described in Item 1 of Schedule 1.

Together, these clauses of the Holding Trust Deeds indicate that the parties intend the Fund to have a fixed entitlement to the income of the Holding Trusts. Therefore, to determine whether income derived by the Fund through the Holding Trusts is non-arm's length income of the Fund, consideration must be given to subsection 295-550(5) of the ITAA 1997.

If that conclusion was incorrect, income derived by the Fund as beneficiary of the Holding Trusts would be non-arm's length income of the Fund under subsection 295-550(4) of the ITAA 1997.

Application of subsection 295-550(5) of the ITAA 1997

In accordance with subsection 295-550(5) of the ITAA 1997, income derived by a superannuation fund 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 fund 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.

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 (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 terms almost identical to a combination of the definitions of 'scheme' and 'arrangement' in the ITAA 1997. The court held that the series of steps undertaken by the parties that resulted in the acquisition of a fixed interest in the trust estate and the relevant distribution of income from that trust estate were readily seen to be an 'arrangement' to which the various entities were parties, and those results were readily seen to be the consequence of that arrangement.

Similarly, for the purposes of applying subsection 295-550(5) of the ITAA 1997 in the present case, the scheme involves the series of steps undertaken by the parties that result in the Fund's acquisition of its fixed entitlement to the income of the Holding Trusts and any derivation of income by the Fund through holding that entitlement. These steps include:

• the acquisition of the shares;

• the establishment and operation of the Holding Trust in favour of the Fund in respect of the shares acquired;

• the acquisition by the Fund of a fixed entitlement to the income of the Holding Trust and the derivation of income by the Fund through holding that entitlement; and

• the establishment and operation of the LRBAs between the Fund Trustee and the Member.

Further, the scheme encompasses any agreement made by the parties to the Loan Agreements concerning the repayment of the principal.

Similarly, those results are readily seen to be the consequence of the above scheme. As such, it is readily concluded that, for the purposes of paragraph 295-550(5)(a) of the ITAA 1997, the Fund would acquire its fixed entitlement to the income of the Holding Trusts under a scheme and any income derived through holding that entitlement would be derived under a 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, consideration is to be given to 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 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 Justices Edmonds and Gordon further stated 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 held that former paragraph 273(7)(a) of the ITAA 1936 - the immediate predecessor of paragraph 295-550(5)(a) of the ITAA 1997 - 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 the income of the trust and any derivation of 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 LRBAs between the Fund and the lender (which includes the establishment and operation of the holding trusts in favour of the Fund in respect of the shares acquired with the borrowed money).

It is clear that the parties in this case are not in an arm's length relationship. This view is based on the fact that the Member is:

• the sole member of the Fund (the beneficiary);

• the sole director and shareholder of the Fund Trustee (the borrower);

• the sole director and shareholder of the Holding Trustee (the custodian); and

• the lender.

Consequently, as Dowsett J stated in AXA, it may be inferred that the dealing between the parties is not at arm's length. That being the case, it is necessary to consider whether the terms of the dealing between the parties can displace the inference based on the relationship of the parties.

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

• The Member is not by way of the charging of interest under the Loan Agreements, or by any other means, compensated for the opportunity cost of lending the principal, or for the additional risk assumed in relation to recovery of the principal in the event of the borrower's default under the Loan Agreements, given the limited recourse nature of the loans and lack of other security.

• No principle payments are required for five years, with voluntary payments allowed at any time during the loan term of 25 years.

• 100% of the value of the shares to be acquired will be lent. Generally, high LVR loans are provided where the risk of default and loss are small. To help mitigate the risk associated with high LVR, lenders will generally require additional terms such as mortgage insurance or an-upfront risk fee. In this case there is no mortgage insurance or upfront risk fee paid under the Loan Agreement.

• If the Fund Trustee were to borrow from an independent lender, it could not reasonably have expected to borrow the entire purchase price without additional security. Alternatively, a commercial lender prepared to lend 100% of the value of commercial property would insist on security over the asset acquired with the borrowed money.

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) of the ITAA 1997, is that the amount of the 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.

If the parties in this case were dealing with each other at arm's length, the amount of income the Fund might be expected to derive through the holding is either:

• nil - on the basis that no lending on the proposed terms by the lender might be expected and therefore no income might be expected to be derived by the Fund through the Holding Trusts; or

• is less than under the proposed arrangement - on the basis that the lender might be expected to lend on commercial terms that involve lower than 100% of the price of the shares given the nature of the assets to be acquired with the borrowed money and the limited recourse nature of the loans. Therefore, the substantially lower borrowed amounts available to be invested might be expected to generate less income to be derived by the Fund through the Holding Trusts than under the proposed arrangement.

Either way, the final requirement of subsection 295-550(5) of the ITAA 1997 is satisfied.

Consequently, income derived by the Fund through the Holding Trusts would be non-arm's length income of the Fund.

Other relevant comments

Legislative intent

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

The earliest predecessor of section 295-550 of the ITAA 1997 - former section 23F of the ITAA 1936 - was introduced in 1964 as a result of the Report of the Commonwealth Committee on Taxation, 1961 (the 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 former section 273 of the ITAA 1936, 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 to the Superannuation Legislation Amendment Bill (No.2) 1999 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 at paragraph 2.13 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 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.

Issue 3

Detailed reasoning

Part IVA of the ITAA 1936 is a general anti-avoidance provision that gives the Commissioner the discretion to cancel all or part of a 'tax benefit' that has been obtained or would, but for section 177 of the ITAA 1936 be obtained, by a taxpayer in connection with a scheme to which Part IVA applies.

Broadly, Part IVA of the ITAA 1936 applies where:

n a taxpayer enters into a scheme

n the taxpayer obtains a tax benefit from the scheme

n the circumstances indicate that the obtaining of that tax benefit was a dominant purpose of one of the parties to the scheme.

Part IVA of the ITAA is a provision of last resort. It does not apply unless the taxpayer's claim is otherwise allowable under tax law.

In light of the ruling given in respect of non-arm's length income of the Fund, please confirm whether the rulee still requires a ruling concerning the application of Part IVA of the ITAA 1936 in relation to the scheme the subject of the private ruling application, or whether the rulee wishes to withdraw their application concerning that matter.

Please be aware that, if contrary to our ruling in respect of non-arm's length income of the Fund, the non-arm's length income provisions do not so apply, it is our preliminary view that Part IVA of the ITAA 1936 could apply.