Edited version of your written advice

Authorisation Number: 1012810305394

Ruling

Subject: Non-arm's length income

Question 1

Can the trustees of a self-managed superannuation fund (the Fund) buy shares from a private company under a term contract?

Answer

Decline to rule

Question 2

Would any dividends received by the Fund from the shares be treated as non-arm's length income of the Fund in accordance with section 295-550 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

This ruling applies for the following periods:

Income year ending 30 June 2015

The scheme commences on:

During the 2014-15 income year.

Relevant facts and circumstances

The Fund is a complying self-managed superannuation fund.

The two members of the Fund (Member 1 and Member 2) are each other spouses.

The trustees of the Fund (the Fund Trustee) are Member 1 and Member 2.

Member 1 is employed by a private company (Company 1). The only shareholder of Company 1 is another private company (Company 2).

The Fund Trustee intends to acquire a parcel of shares in Company 1 (the Shares) from Company 2. The Shares will be purchased at market value.

The Shares will be held on trust for the Fund Trustees in a bare trust (the Holding Trust). The trustee of the Holding Trust (the Holding Trustee) is a private company (Company 3).

The directors and members of the Holding Trustee are Member 1 and Member 2

The Holding Trust Deed made between the Fund Trustee and the Holding Trustee includes the following key terms:

• The Fund Trustee is to provide the whole of the purchase price and any other costs referable to the acquisition of the Shares.

• The Holding Trustee will obtain legal title in, and become the registered proprietor of, the Shares and will hold the Shares under the terms of the Deed.

• The Fund Trustee is absolutely entitled to the Beneficial Interest in the Shares held by the Holding Trustee on behalf of the Fund Trustee.

• Any dividends or other distributions referable to and paid with respect to the Underlying Shares will be derived by the Fund Trustee.

The purchase of the Shares will be financed through a limited recourse borrowing arrangement (the Loan) between the Fund Trustee and Company 2.

The Shares are ordinary shares and hold full voting, dividend and return of capital rights. The total value of the Shares exceeds 5% of the value of the Fund.

The dividends will be paid proportionally to the Shares held. Dividends are paid from profits after allowing for the working capital required by the Company 1 and are expected to be fully franked.

No director of Company 2 is related to the members/trustees of the Fund.

A draft loan agreement (the Loan Agreement) made between Company 2 (the Lender), the Fund Trustee (the Borrower) and Member 1 (the Guarantor) includes the following key features:

• The loan is for the full value of the Shares.

• The annual interest rate is nil. The annual interest rate may be varied upon any event of default, to the Reserve Bank of Australia Cash Rate Target plus 6%.

• The total number of repayments is variable in accordance with dividend paid to the Borrower or the Guarantor.

• The repayment amount is the total amount of dividends paid to the borrower or Guarantor after allowing for taxation.

• The frequency for the payments is variable.

• The final repayment date is mid 2019.

• The repayment method is as agreed between Lender and Borrower from time to time.

• The Guarantor will indemnify the Lender against all loss resulting from the Lender having entered into this Agreement, whether from the Borrower's failure to perform their obligations under it or from this Agreement being or becoming unenforceable against the Borrower.

The Shares will be bought under a separate sale agreement, which provides that:

• Company 2 is the Vendor and legal owner of the Shares.

• The Fund Trustee is the purchaser of the shares.

• The Purchaser has offered to purchase the sale shares from the Vendor, and the Vendor agrees to sell the sale shares to the purchaser, for the Price and on the terms and conditions set out in this Agreement.

• A clause refers to conditions precedent to settlement by the Vendor.

The Vendor's obligation to transfer the Sale Shares and complete the transaction generally is subject to and conditional upon the Purchaser and the Purchaser's Guarantor, on or before the date set out in item 1, entering into a separate Loan Agreement with the Vendor setting out the terms and conditions for the payment of the Price (Loan Agreement) together with another documents required by the Vendor to secure that loan (Security Agreement).

Relevant legislative provisions

Income Tax Assessment Act 1936 Former section 273

Income Tax Assessment Act 1997 Division 295

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)

Income Tax Rates Act 1986 Section 26

Income Tax Rates Act 1986 Section 35

Taxation Administration Act 1953 Section 359-5

Taxation Administration Act 1953 Section 359-35

Reasons for decision

Summary

Any ordinary income or statutory income derived by the Fund as the beneficiary of the Holding Trust will be non-arm's length income of the Fund in accordance with subsection 295-550(5) of the ITAA 1997.

Detailed reasoning

Limited recourse borrowing arrangements

In accordance with subsection 359-5(1) of the Taxation Administration Act 1953 (TAA), the Commissioner may, on application, make a written ruling (called a private ruling) on how the Commissioner considers a relevant provision applies, or would apply, to a particular taxpayer in relation to a specified scheme, arrangement or transaction.

Section 357-55 of Schedule 1 to the TAA specifies the relevant provisions of the Acts and Regulations in respect of which the Commissioner can issue a private ruling and includes the provisions of Acts and Regulations of which the Commissioner has the general administration.

You requested a private ruling on whether the Fund Trustee can buy shares from a private company under a term contract. However, that issue relates to the regulatory provisions contained in the Superannuation Industry (Supervision) Act 1993 (SISA) and/or the Superannuation (Supervision) Regulations 1994 (SISR) of which the Commissioner does not have the general administration. Therefore, we cannot give you a private ruling on that issue.

However, we can provide Self-managed Superannuation Fund specific advice (SMSFSA) about how the SISA and or SISR provisions apply to the Fund in relation to LRBAs.

While similar to a private ruling, SMSFSA is not binding on the Commissioner. A trustee or other entity that relies on SMSFSA will remain responsible for their actions under the SISA and SISR.

However, if the Commissioner later takes the view that the law applies less favourably to an SMSF than SMSFSA indicates, the fact that a trustee acted in accordance with the advice would be a relevant factor in their favour in the Commissioner's exercise of any discretion as to what action to take in response to a breach of the law. This is on the basis that:

• the advice is applicable to the SMSF's particular circumstances;

• the trustee acts, reasonably and in good faith, in accordance with the advice; and

• a full and true disclosure has been made to the Commissioner when the advice is sought.

SMSF Specific Advice

In accordance with section 67 of the SISA, the trustee of a regulated superannuation fund must not borrow money or maintain an existing borrowing of money, except where permitted by the SISA.

Section 67A of the SISA provides an exception to the borrowing prohibition under subsection 67(1) of the SISA if:

(a) the money is or has been applied for the acquisition of a single acquirable asset;

(b) the acquirable asset is held on trust so that the fund trustee acquires a beneficial interest in the acquirable asset;

(c) the trustee has a right to acquire legal ownership of the acquirable asset by making one or more payments after acquiring the beneficial interest;

(d) the rights of the lender or any other person against the trustee for, in connection with, or as a result of (whether directly or indirectly) default on the borrowing (or the sum of the borrowing and charges related to the borrowing) are limited to rights relating to the acquirable asset;

(e) if, under the arrangement, the trustee has a right relating to the acquirable asset (other than a right described in para (c)) - the rights of the lender or any other person against the trustee for, in connection with, or as a result of (whether directly or indirectly) the trustee's exercise of the trustee's right are limited to rights relating to the acquirable asset; and

(f) the acquirable asset is not subject to any charge (including a mortgage, lien or other encumbrance) except as provided by para (d) or (e).

Acquirable asset is defined in subsection 67A(2) of the SISA as an asset that:

(a) is not money (whether Australian currency or currency of another country); and

(b) neither the SISA nor any other law prohibits the trustee from acquiring.

Relevantly, subsection 67A(3) of the SISA states that section 67A applies to a collection of assets in the same way as they apply to a single asset if the assets in the collection are identical to each other and have the same market value as each other, for example, a collection of shares of the same class in a single company.

In this case, the Fund Trustee is purchasing a collection of shares of the same class in a single, unrelated company. The purchase of the shares is to be financed utilising an LRBA whereby the shares are held on trust for the Fund Trustee until the borrowing has been repaid; the rights of the lender are limited to rights relating to the shares and once the borrowing is repaid, the legal ownership of the shares is to pass to the Fund Trustee.

Therefore, based on the above, the borrowing meets the requirements of section 67A of the SISA and the borrowing prohibition in subsection 67(1) of the SISA does not apply in this case.

Detailed reasoning - Question 2

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 a complying superannuation fund's taxable income, 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 and are 15% and 47% respectively for the 2014-15 income year (see sections 26 and 35 of that Act).

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 by an entity 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 in relation to amounts of ordinary or statutory income included in the assessable income of the Fund that are sourced from the Fund Trustee's entitlement as the beneficiary of the Holding 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

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) explains what amounts are considered to be 'special income' under former section 273 of the Income Tax Assessment Act 1936 (ITAA 1936) which was repealed with effect from 1 July 2007.

Although that ruling is primarily concerned with former section 273 of the ITAA 1936, 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 former section 273: see paragraphs 1A and 1C of that ruling, and section 357-85 in Schedule 1 to the TAA 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 idea as the old provision.

In paragraph 102 of TR 2006/7, the Commissioner states 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.

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.

After considering the terms of the Holding Trust Deed, it is clear that the Fund's entitlement to the income of the Holding Trust as the beneficiary of that trust does not depend upon the exercise of the Holding 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 Holding 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 is to be considered further in the present case. If that view is wrong and instead the Fund derives income as a beneficiary of the Holding Trust, other than because of holding a fixed entitlement to the income of that trust, then that income is non-arm's length income of the Fund pursuant to subsection 295-550(4) of the ITAA 1997.

Scheme

Under subsection 295-550(5) of the ITAA 1997 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 referred to in that subsection 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 referred to in that subsection may be identified as involving the series of steps 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 Holding Trust. Those steps resulted in the Fund acquiring its entitlement to the income of the Holding Trust through which entitlement the Fund would 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 ordinary or statutory income derived by the Fund as beneficiary of the Holding Trust through holding its fixed entitlement to the income of that trust is so derived under a scheme.

Parties to scheme not dealing at arm's length

The Commissioner considers that in the present case the parties are not 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) 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 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, amongst other things, the establishment and operation of the LRBA in conformity with section 67A of the SISA, which includes the establishment and operation of the Loan and the Holding Trust of which the Fund is the beneficiary.

It is clear that the parties in this case are not in an arm's length relationship in relation to the Holding Trust. This is because Member 1 and Member 2 are:

• the only members of the Fund;

• the Trustees of the Fund; and

• the directors of the Holding Trust Trustee.

In addition, Member 1 is the Guarantor for the Fund Trustee's liability to the Lender in respect of the LRBA.

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 circumstances holistically, the Commissioner considers that the parties are not dealing with each other in relation to the scheme as arm's length parties would do. Aspects which, taken together, the Commissioner considers lead to that conclusion include:

• The loan amount is 100% of the purchase price of the Shares. Generally, the LVR is used by a lender to limit the lender's loss in the event that a borrower defaults. High LVR loans are generally provided where the risk of default and loss are smaller; low LVR loans are provided where the risk of default and loss are greater. Shares are a high risk asset due to market volatility therefore; an arm's length lender would not lend 100% of the purchase price of shares.

• 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 mentioned in the Loan Agreement.

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

• Rather than having to make regular periodic repayments of the principal sum, the Fund Trustee is required to make repayments if and when dividends in respect of the Shares are paid to the Fund or the Guarantor. At the final repayment date, a single lump repayment is to be made to cover the balance of the principle amount remaining.

• The repayment amount is not set but is to be equal to the value of dividends paid to the Fund or the Guarantor.

• Banks commonly require personal guarantees for LRBAs that have a standard LVR, let alone a 100% LVR. Consequently in the circumstances, an arm's length lender would still require additional security such as mortgage insurance or actual security over a separate asset that they could have recourse to in case of default. Therefore, personal guarantee to be provided by Member 1 does not adequately address the risk of default by the Fund Trustee.

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

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 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."

If the parties to the scheme in this case were dealing with each other at arm's length, the amount of ordinary or statutory income the Fund might be expected to derive as beneficiary of the Holding Trust is nil. It might be expected that an arm's length lender would not lend any capital on the loan terms that form part of the scheme. Without that loan it might be expected that there would be no investment in the assets through the Holding Trust and so no ordinary or statutory income might be expected to be derived by the Fund as beneficiary of the Holding Trust.

It is no answer to this conclusion to say that the Fund could have obtained a loan from an arm's length lender on different terms, or that the Fund could have used other means by which to acquire the asset, as that is not the scheme into which the parties have proposed to enter into. The comparison contemplated by paragraph 295-550(5)(b) of the ITAA 1997, as explained by the Full Federal Court in Allen v Federal Commissioner of Taxation (2011) 195 FCR 416, is made between what actually occurred as part of the scheme and what might be expected to have occurred if the parties to the scheme had been dealing with each other at arm's length in relation to the scheme.

The Commissioner considers that the final requirement of subsection 295-550(5) of the ITAA 1997 is satisfied. Therefore, any ordinary or statutory income derived by the Fund as beneficiary of the Holding Trust will be non-arm's length income of the Fund pursuant to section 295-550 of the ITAA 1997.