Edited version of your written advice

Authorisation Number: 1051224611153

Date of advice: 16 May 2017

Ruling

Subject: Non-arm's length income

Questions

Is royalty income receivable by the Fund non-arm's length income in the Fund for the purposes of subsection 295-550(1) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Advice/Answers

Yes.

This ruling applies for the following period

Income year ended 30 June 20ZZ

The scheme commenced on

1 July 20YY

Relevant facts and circumstances

The Fund was established in the advised income year.

The members of the Fund are Member 1 and Member 2.

The members of the Fund are also the trustees of the Fund.

Member 1 is a partner in a partnership (the Partnership).

In 20WW a property (Property 1) was purchased by the Partnership with the view of the property being a new business site.

In 20XX a property (Property 2) immediately adjoining the proposed new business site was purchased by the Fund from an unrelated vendor.

Property 2 is held in the trustees' name as joint tenants.

A development application over Property 1 and Property 2 was lodged for the operation of a business over both properties. The development application has since been approved. The development application is only effective if both properties continue to operate as intended.

A company (the Company) was established to operate the business.

Member 1 is an Executive Director of the Company.

The trustees of the Fund and the Company are entering into an agreement to pay a royalty payment of one half of the market price for royalties at the time of the business opening to the Fund for the lease of Property 2.

You supplied a copy of a pre-existing royalty agreement between two unrelated parties (the third party agreement)

The third party agreement states that:

● A royalty will be charged per tonne above a set tonnage.

● the royalty payment will be revised annually in accordance to the index sale price to a Basket of Material.

● the royalty payment will be increased by the percentage increase in the selling price of the Basket of Material over the previous two years.

The agreement between the members and the Company:

● has a higher rate of royalty per tonne and a upward sliding scale of royalty per tonne when compared to the third party agreement.

● does not specify that the royalty payment were only payable where the material sold has a value in excess of a set price per tonne.

● has a different method of adjusting for the royalty per tonne with each succeeding year.

● allows for the non-payment of royalty where the royalty payable for any month in arrears is less than or equal to the rent paid or payable.

Relevant legislative provisions

Income Tax Assessment Act 1936 Section 273

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)

Reasons for decision

Summary

The royalty income receivable by the Fund is non-arm's length income.

Detailed Reasoning

Non-arm's length income

In accordance with section 295-545 of the Income Tax Assessment Act 1997 (ITAA 1997) the income of a complying superannuation fund, complying approved deposit fund or pooled superannuation trust is split into a 'non-arm's length component' and a 'low tax component'.

The non-arm's length component (formerly known as special income) comprises non-arm's length dividends received from private companies, non-fixed interest trust distributions, and any income derived from transactions where the parties are not dealing with each other at arm's length. This component is reduced by any deductions attributable to that income and is then taxed at the highest marginal rate. 'Derived' in this context is applicable to both ordinary and statutory income.

The remaining part of the entity's taxable income for the income year is the low tax component which is taxed at a concessional rate (currently 15 per cent).

The Commissioner has issued Taxation Ruling TR 2006/7, titled 'Income tax: special income derived by a complying superannuation fund, a complying approved deposit fund or a pooled superannuation trust in relation to the year of income' (TR 2006/7). This ruling refers to the former section 273 of the Income Tax Assessment Act 1936 (ITAA 1936) which concerned 'special income' and still provides useful guidance on the factors to be considered in the interpretation of section 295-550 of the ITAA 1997.

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

The non-arm's length provisions require the determination of whether the parties to the scheme are dealing with each other at arm's length in relation to the scheme.

'Arm's length' is not defined, however subsection 995-1(1) of the ITAA 1997 states that:

in determining whether parties deal at arm's length, consider any connection between them and any other relevant circumstance.

In relation to arm's length TR 2006/7 states at paragraph 76 to 78:

76. The Commissioner considers that parties are dealing with each other at arm's length in relation to a transaction if the independent minds and wills of the parties are applied to the transaction and their dealing is a matter of real bargaining. If this is not the case, the Commissioner will consider that the parties are not dealing with each at arm's length in relation to the transaction.

77. If the relationship of the parties is such that one party has the ability to influence or control the other, this will suggest that the parties may not be dealing at arm's length, but it will not be determinative.

78. Parties that are not at arm's length can deal with each other at arm's length in relation to a transaction and parties that are at arm's length can deal with each other in a way that is not at arm's length. An amount of income can only be special income under subsection 273(4) if, in relation to the particular transaction, the parties are not dealing with each other at arm's length.

This view is based on the decisions in Re Hains (deceased), Barnsdall v. FC of T (1988) 88 ATC 4565; (1988) 81 ALR 173; (1988) 19 ATR 1352, Re Trustee of the Estate of the late AW Furse (1990) 21 ATR 1123; (1990) 91 ATC 4007, and Granby Pty Ltd v. FC of T (1995) 129 ALR 503; (1995) 30 ATR 400; (1995) 95 ATC 4240 and the examples in the Explanatory Memorandum to the Superannuation Legislation Amendment Bill (No. 2) 1999, which, as enacted, inserted subsections 273(6) to (8) of the ITAA 1936.

These cases were also relied upon in Allen (As Trustee of the Allen's Asphalt Staff Superannuation Fund) v. Federal Commissioner of Taxation [2010] FCA 1276; (2010) 2010 ATC 20-225; (2010) 80 ATR 849; [2012] ALMD 2629; [2012] ALMD 2630; [2012] ALMD 2631; [2012] ALMD 2632 case where Justice Collier said:

…if conduct of parties is not consistent with conduct of independent third parties, because one party is exerting personal influence or control over the other or others, dealings between them cannot be termed 'arm's length'.

Further, consideration must be given to whether the amount derived from the scheme is more than the amount the fund might have been expected to derive if those parties had been dealing with each other at arm's length in relation to the scheme.

In relation to the above paragraphs 79 and 80 of TR 2006/7 state:

79. The final requirement for an amount of income to be special income under subsection 273(4) is that the amount of income derived from the transaction must be greater than the amount of income that might have been expected if the parties were dealing with each other at arm's length in relation to the transaction.

80. This is a question of fact. When considering this issue, the Commissioner will take into account all relevant matters. The level of investment risk that the superannuation entity is exposed to will be a relevant matter.

In Syngenta Crop Protection Pty Ltd v. Federal Commissioner of Taxation
[2005] FCA 1646; (2005) 61 ATR 186; [2008] ALMD 422 Justice Gyles, discussing arm's length consideration in the context of the transfer pricing provisions held that the test for determining excessive income was objective, stating:

The question as to whether the consideration is that which might reasonably be expected to have been received or receivable as consideration in either a supply or acquisition if the property had been supplied or acquired under an agreement between independent parties dealing at arms length is an objective question. It does not depend upon anybody's opinion, save that of the court or body making that decision. It is a matter for evidence…

In this case, in 20XX Property 2, was purchased by the Fund from an unrelated vendor. A development application over Property 1 and Property 2 was lodged for the operation of a business over both properties.

Property 1 was purchased by a partnership of which Member 1 is a partner of the Partnership.

The Company was established to operate the business. Member 1 is an Executive Director of the Company.

The trustees of the Fund and the Company are entering into an agreement for the lease of Property 2.

As a member of the Fund and Executive Director of the Company and a partner in the Partnership it could be said that the member is in a position to influence the decisions of the Partnership, the Company and the Fund.

You advise that the royalty payments to the Fund are similar to the third party agreement that you supplied. However, it is noted that there are key and significant differences between the two agreements. The agreement between the members of the Fund and the Company:

● has a higher rate of royalty per tonne and a upward sliding scale of royalty per tonne when compared to the third party agreements has a fixed rate of royalty.

● does not specify that the royalty payment were only payable where the material sold has a value in excess of a set price per tonne.

● has a different method of adjusting for the royalty per tonne with each succeeding year.

● allows for the non-payment of royalty where the royalty payable for any month in arrears is less than or equal to the rent paid or payable.

Based on the facts above, it cannot be accepted that the royalty payments receivable by the Fund results in a reasonable market value with objective and supportable evidence. Therefore the royalty payments received by the Fund are not considered to have been made on an arm's length basis.