Edited version of private advice

Authorisation Number: 1052045211374

Date of advice: 15 November 2022

Ruling

Subject: Non-arm's length income

Question

Does the provision of taxation and accounting services for no cost cause an amount of ordinary income or statutory income to be 'non-arm's length income' within the meaning of that term in section 295-550 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

This ruling applies for the following period:

Income year ending 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

Individual:

•         has not provided any tax and accounting services to the public for a number of years;

•         only provides services to family members and their associated entities; the total tax returns lodged in a year are 18 including their own;

•         also prepares the accounts and tax returns for the superannuation fund for which they are the trustee;

•         mentors some small businesses on a volunteer basis;

•         provides all services on a pro bono basis; and

•         has a home office which is used to prepare the accounts and tax returns for family members as well as handling personal matters using equipment purchased personally.

For its convenience the tax returns are lodged under an Associated Tax Agent registration. This entity is associated with the Individual.

The Associated Tax Agent has no assets or liabilities and does not have office premises or any equipment. It has no income or expenses and does not need to lodge tax returns.

Individual provides accounting and taxation services to a self-managed superannuation fund (Fund) which is an associated entity of a close family member of Individual for no fee.

Individual is not a member or an office holder of the corporate trustee of the Fund.

Relevant legislative provisions

Income Tax Assessment Act 1997

section 295-545

subsection 295-545(1)

section 295-550

paragraph 295-550(1)(c)

section 275-610

section 995-1

Reasons for decision

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 the complying superannuation fund's taxable income, while the non-arm's length component is taxed at the highest marginal rate.

Subsection 995-1(1) of the ITAA 1997, provides that 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 (NALI) for that year less any deductions to the extent that they are attributable to that income. Subsection 995-1(1) of the ITAA 1997 provides that the phrase 'non-arm's length income' has the meaning given by section 295-550 of the ITAA 1997 and section 275-610 of the ITAA 1997.

Relevantly 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 entity if, as a result of a scheme the parties to which were not dealing with each other at arm's length in relation to the scheme, one or more of the following applies:

...

(c) in gaining or producing the income, the entity does not incur a loss, outgoing or expenditure that the entity might have been expected to incur if those parties had been dealing with each other at arm's length in relation to the scheme.

This subsection does not apply to an amount to which subsection (2) applies or an amount derived by the entity in the capacity of beneficiary of a trust.

The Explanatory Memorandum to the Treasury Laws Amendment (2018 Superannuation Measures No.1) Bill 2018 explains the intended operation of paragraph 295-550(1)(c) of the ITAA 1997:

A new provision is added to ensure that a superannuation entity's non-arm's length income includes income where expenditure incurred in gaining or producing it was not an arm's length expense. This includes where no expense was incurred (but might be expected to have been incurred if the transaction were on arm's length terms).

Subsection 995-1(1) of the ITAA 1997 states that 'scheme' means:

(a) Any arrangement; or

(b) Any scheme, plan, proposal, action, course of action or course of conduct, whether unilateral or otherwise.

and that an 'arrangement' means:

Any arrangement, agreement, understanding, promise or undertaking, whether express or implied, and whether or not enforceable (or intended to be enforceable) by legal proceedings.

Individual has not charged the trustee of the Fund for providing tax and accounting services for the Fund. As such, consideration needs to be given to whether paragraph 292-550(1)(c) of the ITAA 1997 would apply.

Not dealing with each other at arm's length

The phrase 'at arm's length' has been considered in a number of decisions and used in various legislative contexts. As explained by Davies J in Re Hains (deceased); Barnsdall v. Federal Commissioner of Taxation(1988) 81 ALR 173 at 176 (Barnsdall) the term 'at arm's length' was developed in the law with respect to transactions between persons, one of whom, such as a trustee or a solicitor, is in a position of special influence with respect to the other, a beneficiary or client. His Honour referred to the classic statement of principles found in the speech of Lord O'Hagan in Macpherson v. Watt (1877) 3 App Cas 254 at 266; (1988) 81 ALR 173 at 176.

Davies J pointed out, however, that such cases are of little assistance in the interpretation of statutes which are concerned with taxation.

His Honour then referred to the interpretation of the phrase 'not at arm's length' that was provided in Australian Trade Commission v. WA Meat Exports Pty Ltd (1987) 75 ALR 287; (1988) 81 ALR 173 at 176. The Federal Court decided in that case that the ordinary meaning of the phrase applies. The Federal Court concluded that the ordinary meaning of the phrase 'not at arm's length' is the circumstance where one party 'has the ability to exert personal influence or control over the other'

Although the ability of one party to influence or control the other party to the transaction is an important issue to consider for the purposes of applying the arm's length requirement in subsection 295-550(1) of the ITAA 1997, it is not the only issue to consider. Subsection 295-550(1) of the ITAA 1997 requires the parties to the transaction to be 'not dealing with each other at arm's length'.

The provision with which Davies J was concerned in Barsndall was in similar terms:

If the term were simply 'not at arm's length', Australian Trade Commission v. WA Meat Exports Pty Ltd (1987) 75 ALR 287 would apply.... However, s 26AAA(4) [of the ITAA 1936] used the expression 'not dealing with each other at arm's length'. That term should not be read as if the words 'dealing with' were not present. The Commissioner is required to be satisfied not merely of a connection between a taxpayer and the person to whom the taxpayer transferred, but also of the fact that they were not dealing with each other at arm's length. A finding as to a connection between the parties is simply a step in the course of reasoning and will not be determinative unless it leads to the ultimate conclusion.

This interpretation of the phrase 'not dealing with each other at arm's length' was adopted for the purposes of interpreting the same phrase in subsection 102AG(3) of the ITAA 1936 by the Federal Court in The Trustee for the Estate of the late AW Furse No. 5 Will Trust v. FC of T (1990) 21 ATR 1123; 91 ATC 4007 (Furse). Hill J noted:

The first of the two issues [i.e. whether the parties to the relevant agreement were dealing with each other at arm's length] is not to be decided solely by asking whether the parties to the relevant agreement were at arm's length to each other. The emphasis in the subsection is rather upon whether those parties, in relation to the agreement, dealt with each other at arm's length. The fact that the parties are themselves not at arm's length does not mean that they may not, in respect of a particular dealing, deal with each other at arm's length. This is not to say that the relationship between the parties is irrelevant to the issue to be determined under the subsection. The distinction was pointed out by Davies J in connection with similar words used in sec. 26AAA(4) of the Act in Barnsdall v. FC of T 88 ATC 4565 at p. 4568, in a passage which with respect I agree:...

What is required in determining whether parties dealt with each other in respect of a particular dealing at arm's length is 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.

The point made by Davies J in Barnsdall and Hill J in Furse is that a relationship between two parties does not necessarily mean that the parties cannot deal at arm's length in relation to a particular transaction. As emphasised by Hill J in Furse, however, the relationship between the parties is relevant. It is, in the words of Davies J in Barnsdall, 'a step in the course of reasoning'.

In line with Hill J's comments in Furse, the Commissioner will consider that parties are not dealing with each other at arm's length when they are not involved in real bargaining.

Both Barnsdall and Furse have gained further support from the Federal Court in Granby Pty Ltd v. Federal Commissioner of Taxation (1990) 21 ATR 1123; 91 ATC 4007, this time in the capital gains tax context. For the purposes of determining the cost base of an asset under subsections 160ZH(1), (2) and (3), paragraph 160ZH(9)(c) of the Income Tax Assessment Act 1936 provides that the taxpayer shall be deemed to have paid market value if, amongst other things, the taxpayer and the vendor were not dealing with each other at arm's length in connection with the acquisition. In Granby Pty Ltd v. Federal Commissioner of Taxation (1995) 129 ALR 503 at 507, Lee J followed Barnsdall and Furse and added:

... the term 'at arm's length' means, at least, that the parties to a transaction have acted severally and independently in forming their bargain....

If the parties to the transaction are at arm's length it will follow, usually, that the parties will have dealt with each other at arm's length. That is, the separate minds and wills of the parties will be applied to the bargaining process whatever the outcome of the bargain may be.

That is not to say, however, that parties at arm's length will be dealing with each other at arm's length in a transaction in which they collude to achieve a particular result, or in which one of the parties submits the exercise of its will to the dictation of the other, perhaps, to promote the interests of the other. As in Minister of National Revenue v. Merritt 69 DTC 5159 at 5166 where the parties to the transaction were parties at arm's length, the terms of a loan transaction made between them had been dictated by a unilateral decision of one of them and no independent will in the formation of that transaction had been exercised by the other.

Although Davies J was correct in identifying a connection between the parties as a step in the course of reasoning, it is not a necessary step. As Lee J explains, parties at arm's length may not deal at arm's length when they collude to achieve a particular result or when one of the parties submits the exercise of its will to the dictation of the other.

The comments made by Lee J, along with those of Davies J and Hill J, apply equally to subsection 295-550(1) of the ITAA 1997. 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 with each other at arm's length', but it will not be determinative. The Commissioner will only be satisfied that the parties are not dealing with each other at arm's length in relation to a transaction if it is established that the independent minds and wills of the parties are not applied to the transaction such that their dealing is not a matter of real bargaining.

In Law Companion Ruling LCR 2021/2 Non-arm's length income - expenditure incurred under a non-arm's length arrangement (LCR 2021/2), the Commissioner clarifies how section 295-550 of the ITAA 1997 operates in relation to a scheme where the parties do not deal with each other at arm's length and the trustee of a complying superannuation entity incurs non-arm's length expenditure (or where expenditure is not incurred) in gaining or producing ordinary or statutory income.

The Commissioner at paragraphs 51 to 52 states:

51. A complying superannuation fund might enter into arrangements that result in it receiving discounted prices. Such arrangements will still be on arm's length terms where they are consistent with normal commercial practices, such as an individual acting in their capacity as trustee (or a director of a corporate trustee) being entitled to a discount under a discount policy where the same discounts are provided to all employees, partners, shareholders or office holders.

52. Further, services provided to a complying superannuation fund on a pro bono basis will also still be on arm's length terms where the trustee (or director of a corporate trustee) of the fund is not able to influence the service provider's decision to supply the services on a pro bono basis. Application of subsection 295-550(1)(c) of the ITAA 1997

The accounting and taxation services were provided using the Associated Tax Agent's tax agent number. The Tax Practitioner's Board governs the licensing and registration of tax agents. The Associated Tax Agent is a registered tax agent. Registration, amongst other things, is a requisite for a tax agent number and access to the ATO electronic interface systems including the practitioner lodgment service (PLS) and Online services for agents- which are forfeited upon the surrender or cancellation of registration. The Commissioner does not consider that an entity providing accounting and taxation services in these circumstances only to entities with a familial relationship at no charge is consistent with normal commercial practice.

In this case, for the purposes of paragraph 295-550(1)(c) of the ITAA 1997, the scheme involves Individual providing taxation and accounting services for no fee to the Fund. Individual only provides taxation and accounting services for no fee to entities with a familial relationship. The (lack of) price charged to the Fund by Individual and the Associated Tax Agent constitutes a non-arm's length dealing, which resulted in the Fund incurring expenditure in gaining or producing income that was less than would otherwise be expected if those parties were dealing with each other at arm's length in relation to the scheme.

As such, there is sufficient nexus between the non-arm's length expenditure and the income derived from the Fund. Consequently, the provision of the accounting and taxation services to the Fund would result in the income of the Fund being non-arm's length income pursuant to subsection 295-550(1) of the ITAA 1997. The Fund income will therefore be non-arm's length income for each income year the non-arm's length dealing remains in place.