Private ruling: Non-arm's length income
Published: April 2015
Ruling period: Income year ending 30 June 2015 | Income year ending 30 June 2016
Date scheme commenced: 1 July 2014

Ruling: Q1: 1. Will the dividend income and eventual capital gains realised by the Fund in respect of a parcel of the shares acquired by the Fund with monies from a related family trust be considered non-arm's length income of the Fund under section 295-550 of the Income Tax Assessment 1997 (ITAA 1997)? 2. If a discounted amount of interest was utilised under this arrangement (i.e. the difference between interest calculated using an arm's length interest rate and that of the loan agreement) would it be considered a superannuation contribution received by the Fund? 3. If the personal guarantee is called upon, will this amount be considered a contribution to the Fund? 4. Will the purchase of the Shares by the Fund be deemed a scheme with the dominant purpose of gaining a benefit under Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936)? | A1: 1. Yes. 2. No. 3. Yes. 4. The Commissioner has not yet ruled

Relevant facts and circumstances: The Fund is a regulated self-managed superannuation fund. Currently, the Fund is in accumulation phase. The Fund has two members (Member 1 and Member 2) who are each other's spouse. The trustee of the Fund (Fund Trustee) is a private company. Directors and members of the Fund Trustee are Member 1 and Member 2. Member 1 will acquire the Shares under an employee share scheme. Tax will be paid on the market value of the Shares on the date the Shares become available to Member 1. Member 1 is able to acquire the Shares only at certain times of the year due to the governance requirements which prevent them from acquiring the Shares during specified times. As a result, the Shares will be purchased in a number of tranches. Shares purchased in each tranche will be identical. The Fund Trustee intends to acquire the Shares from Member 1 at market price on the date of acquisition. Each tranche of the Shares will be held on trust in a separate bare trust (the Holding Trust) for the benefit of the Fund Trustee. The trustee of all the Holding Trusts (the Holding Trustee) will be another private company. The terms of the Holding Trust Deeds will be identical. A draft Bare Trust Deed includes the following terms: • The Beneficiary is absolutely entitled to the benefit of the Asset together with all earnings, profits or gains accrued or to accrue in respect of the Asset. • The Trustee or its successors will execute and deliver, when called upon by the Beneficiary, a transfer of the Asset to the Beneficiary (Clause 5). • The Trustee undertakes to deal with the Asset and exercise and perform all the rights, duties and powers relating to the Asset only as directed by the Beneficiary. The purchase of the Shares by the Fund Trustee will be financed through a number of limited recourse borrowing arrangements (LRBAs). The lenders (the Lender) in each case will be a trustee company for a family trust (the Family Trust). Member 1 and Member 2 are directors and members of the Family Trust trustee and the primary beneficiaries of the Family Trust. The funds to be lent to the Fund Trustee will be gifted to the Family Trust by Member 1 or Member 2. A separate loan agreement (the Loan Agreement) will be made with respect to each LRBA. All the Loan Agreements will be identical A draft Loan Agreement includes the following terms: • The Lender has agreed to advance a maximum amount not exceeding the Facility Amount. • The Lender may increase the Facility Amount at its discretion. • The term of the loan is seven years from the last day of the financial year in which the Commencement Date occurs, or as otherwise agreed to from time to time by the written consent of the parties. • A repayment of principal and interest is to be made on the last business day of each year. • Interest rate is the benchmark interest rate outlined in section 109N(2) of the ITAA 1936. • The Lender's rights against the Borrower are limited to rights relating to the Asset only. • The Lender may hold a security or guarantee from other parties in relation to the Loan. The Loan to Valuation Ratio (LVR) in respect of each loan is equal to 100% of the asset value. The Lender will require the Fund Trustee to procure the provision of a personal guarantee from Member 1 and Member 2 (in their personal capacity). The security will be strictly limited to being satisfied by personal assets outside the Fund. A draft Guarantee & Indemnity deed (Indemnity Deed) made between Member 1 and Member 2 (the Guarantor), the Fund Trustee and the Lender includes the following terms: • The rights of the Guarantor on default on the borrowing are limited to the rights relating to the Asset. • The Guarantor guarantees to the Lender performance by the Fund Trustee under the Loan Agreement. • If the Fund Trustee defaults in either the payment of money or in the performance of any obligations under the Loan Agreement, the Guarantor must pay any such money to the Lender and indemnify the Lender for all losses reasonably incurred in respect of the default. • The Guarantor has no rights of subrogation in respect of the Fund Trustee until all amounts due to the Lender under the Loan Agreement have been fully paid. • The Guarantor must not exercise any rights of subrogation in respect of the Fund Trustee that are in competition with the rights of the Lender.

Relevant legislative provisions: Income Tax Assessment Act 1936 Former 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) | Superannuation Industry (Supervision) Act 1993 Section 67A All legislative references are to the ITAA 1997 unless stated otherwise.

Reasons for decision: Summary: Any ordinary or statutory income derived by the Fund as beneficiary of the Holding Trusts will be non-arm's length income of the Fund. The difference between an arm's length interest rate and that specified in the Loan Agreement would not increase the capital of the Fund. Therefore, the interest saving achieved by the Fund through a discounted interest rate would not be considered a contribution for the purposes of the ITAA 1997. If, after the disposal of the original asset, a guarantee for a shortfall is called upon in accordance with the terms of the Guarantee & Indemnity agreement, the shortfall amount would be considered a contribution for the purposes of the ITAA 1997 The Commissioner has not yet ruled on whether Part IVA of the ITAA 1936 would apply to the LRBAs. | Detailed Reasoning - Question 1: Non-arm's length income: Section 295-545 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 of the complying superannuation fund's taxable income, while the non-arm's length component is taxed at the highest marginal rate. According to subsection 995-1(1), the phrase 'non-arm's length component' has the meaning given by section 295-545. Subsection 295-545(2) 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), the phrase 'non-arm's length income' has the meaning given by section 295-550. There are various subsections in section 295-550 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) specifically apply to such amounts derived as a beneficiary of a trust. Subsection 295-550(4) 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) 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. | Detailed Reasoning - Income derived as a beneficiary of a trust: Subsections 295-550(4) and (5) are relevant to the present case (and not subsection 295-550(1), which does not apply to amounts derived by a complying superannuation fund in the capacity of beneficiary of a trust) in relation to amounts included in the assessable income of the Fund that are sourced from the Fund Trustee's entitlement as the beneficiary of a 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). | Detailed Reasoning - Fixed entitlement to income derived as a beneficiary of a trust: In paragraph 102 of 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), the Commissioner sets out his view 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 '. Although that ruling is primarily concerned with the former section 273 of the Income Tax Assessment Act 1936 (ITAA 1936) - the immediate predecessor of section 295-550 - it is also taken to be a ruling about section 295-550 to the extent that it addresses issues in section 295-550 that are the same as were in the former section 273: see paragraphs 1A and 1C of that ruling, and section 357-85 in Schedule 1 to the Taxation Administration Act 1953 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 ideas as the old provision. Indeed, 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). It is clear from the draft Holding Trust Deed that the Fund's entitlement to the income of the Holding Trusts as the beneficiary of those 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 Trusts through the holding of a fixed entitlement to the income of those trusts. Therefore, it is subsection 295-550(5), rather than subsection 295-550(4), that is to be considered further in the present case. If that view is wrong and instead the Fund derives ordinary or statutory income as a beneficiary of the Holding Trusts, other than because of holding a fixed entitlement to the income of those trusts, then that income will be non-arm's length income of the Fund pursuant to subsection 295-550(4). | Detailed Reasoning - Scheme: For subsection 295-550(5) to apply, 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) 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) 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). 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), the scheme 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) in the present case, the scheme may be identified as involving the series of steps to be undertaken to give effect to the LRBAs in conformity with the requirements of section 67A of the Superannuation Industry Supervision Act 1993 (SISA). The scheme includes the establishment and operation of the loans and the Holding Trusts. Those steps will result in the Fund acquiring its entitlement to the income of the Holding Trusts through which entitlement the Fund will derive ordinary or statutory income as the beneficiary of those trusts. 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), the Fund will acquire its fixed entitlement to the income of the Holding Trusts under a scheme, and the ordinary or statutory income derived as the beneficiary of the Holding Trusts through holding that entitlement will be derived under a scheme. | Detailed Reasoning - 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) 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) - 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 the establishment and operation of the LRBAs (which includes the establishment and operation of the loans and the Holding Trusts of which the Fund is the beneficiary). It is clear that the parties in this case are not in an arm's length relationship. This is because the two individuals involved (Member 1 and Member 2) are: • the only members of the Fund (the beneficial owner of the asset); • the directors and members of the Fund Trustee (the borrower); • the directors and members of the Holding Trustee (the legal owner of the asset); • the directors and members of the Family Trust trustee; (the Lender) • the primary beneficiaries of the Family Trust; and • the Guarantor for the Fund Trustee's liability to the Lender in respect of the LRBAs. In addition, Member 1 is the owner of the Shares to be acquired by the Fund and either Member 1 or Member 2 will gift to the Lender the funds required to make the loans to the Fund Trustee. 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 has 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 term of the loan may be extended from time to time as agreed between the parties. This indicates that the term of the loan can be extended at the discretion of the Lender and the Fund Trustee. • Repayments of principal and interest are made on a yearly, rather than a more regular (eg, monthly) basis; • The interest rate is set with reference to the RBA's standard variable housing loan interest rate. However, in this case the loans are not over residential property but over shares, which are a more volatile asset and therefore, a greater risk than property. To mitigate the risk, an arm's length lender would charge a higher interest rate to reflect the nature of the asset borrowed against. • Even if there was no disparity between the type of asset borrowed against, the RBA's variable housing loan interest rate is not at arm's length as this is the rate for a standard housing loan - not a limited recourse loan to a self-managed superannuation fund. • Banks commonly require personal guarantees for LRBAs that have a standard LVR, let alone a 100% LVR. Therefore, 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 the members of the fund 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) are satisfied. | Detailed Reasoning - Amount of income greater than might be expected if dealing at arm's length: The final requirement of subsection 295-550(5), which is set out in paragraph 295-550(5)(b), 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) - 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 Trusts is nil. It might be expected that an arm's length lender would not lend any capital for the acquisition of this asset on the loan terms that form part of the scheme. Without the loans it might be expected that there would be no investment in the asset through the Holding Trusts and so no ordinary or statutory income might be expected to be derived by the Fund as beneficiary of the Holding Trusts. It is no answer to this conclusion to say that the Fund Trustee could have obtained loans from an arm's length lender on different terms, or that the Fund Trustee could have used other means by which to acquire the Asset, as that is not the scheme into which the parties have entered. The comparison contemplated by paragraph 295-550(5)(b), 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 conclusion in this case is analogous to the conclusion of the Full Federal Court in Allen v Federal Commissioner of Taxation (2011) 195 FCR 416 at 429 that 'It requires little imagination to see that if the parties to the movement of funds in this case had been at arm's length, there would have been no distribution at all to the Super Fund.' The Commissioner considers that the final requirement of subsection 295-550(5) is satisfied. Therefore, any ordinary or statutory income derived by the Fund as beneficiary of the Holding Trusts will be non-arm's length income of the Fund. | Detailed Reasoning - Question 2: Meaning of 'contribution': The term 'contribution' is not defined in the ITAA 1997. 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. The Commissioner's view on the meaning of 'contribution' in the superannuation context is set out in Taxation Ruling TR 2010/1 (TR 2010/1). At paragraph 4 of TR 2010/1, the Commissioner 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. An arrangement to reduce the interest expense in respect of a borrowing by a superannuation fund is similar to examples 2 and 5 in paragraphs 75; 76; 81 and 82 of TR 2010/1 therefore, there is no increase in the capital of the superannuation fund and no contribution is made to the superannuation fund under such an arrangement. Accordingly, a saving on the interest expense of the Fund, that is, the difference between a market rate of interest expense and the discounted interest expense, is not considered to be a contribution for the purposes of the ITAA 1997. | Detailed Reasoning - Question 3: Personal guarantee: In accordance with paragraph 34 of the TR 2010/1, the capital of a fund is increased when a person pays an amount to a third party to satisfy a liability of a superannuation provider to that third party. The payment to the third party for the superannuation provider's benefit is constructively received by the provider, and the capital of the superannuation fund is increased by the satisfaction of the fund's liability provided that the person is not entitled to be reimbursed from the fund. However, to be a 'contribution', the increase in the capital of the fund must be provided by a person whose purpose is to benefit one or more particular members of the fund or all of the members in general. Relevantly, paragraph 147 of the TR 2010/1 states: … a guarantor who satisfies a loan obligation of a superannuation provider may be taken to benefit the fund members in circumstances where the guarantor has no, or forgoes their right of, redemption against the superannuation provider. There may be a commercial reason for providing the guarantee (for example, the loan would not have been made to the superannuation provider without the guarantee) or indeed for satisfying the liability of the fund (the contractual requirements of the guarantee itself). However, the failure to deal with superannuation provider on a similar commercial basis in satisfying the fund's obligation means that it may be reasonably inferred that the guarantor's purpose is to provide benefits for the members of the fund. In this case, the Guarantor's right against the Fund Trustee is limited to the rights relating to the Shares. Consequently, once the Fund Trustee disposes of the Shares, the Guarantor's rights come to an end and the Guarantor has no further rights against the Fund Trustee. Therefore, based on the above, if the Lender called on the Guarantor for a shortfall after the disposal of the original asset (the Shares), ,the shortfall amount would be a contribution for the purposes of the ITAA 1997. | Detailed Reasoning - Question: Part IVA of the ITAA 1936: The Commissioner has not yet ruled on the application of Part IVA of the ITAA 1936 in relation to the scheme, which is the subject of this private ruling application. 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. 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 this 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 in the circumstances.