Private ruling: Non-arm's length income
Published: June 2012
Ruling period: Year of income ending 30 June 2012 | Year of income ending 30 June 2013 | Year of income ending 30 June 2014
Date scheme commenced: 1 July 2010

Ruling: Q1: Will income derived by a superannuation fund (the Fund) from a commercial property (the Commercial Property) be non-arm's length income of the Fund under section 295-550 of the Income Tax Assessment Act 1997 if the Commercial Property is operated by a company (the Company) as manager on behalf of the trustee of the Fund? Advice/Answers No

Relevant facts and circumstances: This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling. Member A and Member B are: (a) the sole members of the Fund, a complying superannuation fund; (b) the sole directors and shareholders of the corporate trustee of the Fund (the Fund Trustee); (c) the equal shareholders of the Company, a private company registered a number of years ago; (e) the principal beneficiaries of a discretionary trust (the Discretionary Trust) which, until the second quarter of the relevant income year, owned the Commercial Property; (f) the sole unit holders in another trust (Unit Trust 1) through which a certain business is operated; and (g) the sole unit holders in a unit trust (Unit Trust 2) which owns a commercial property. Member A is also the sole director and the company secretary of the corporate trustee of the Discretionary Trust. Member A develops strategies for development and improvement of entities under their control, being the sole director and the company secretary of the Company, which serves as the 'head-office' company of, and provides management services to, these entities. In particular, the Company: (a) owns and operates a certain business; (b) provides management expertise for the business operated by Unit Trust 1; (c) is the lessee of the commercial property owned by Unit Trust 2; (d) provides management services, including facilities-management services, to Unit Trust 2; and (e) leases and operates the Commercial Property, currently on a month-to-month basis. Member B also performs an executive role by supervising and authorising most of the payments prepared by employees. Apart from having several senior executives, the Company also has a number of employees who attend to payroll, perform data entry, process invoices, prepare reconciliations and prepare payments for authorisation for all entities in the group. Other management services provided by the Company to these entities include: · employee recruitment; · training of employee; · control of room stock and tariff; · advertising and promotions; · website services; · design assistance; · supervision of plant and equipment acquisition, testing and commissioning; · supervision of building works. The Company receives management fees from these entities in return for the services it provided to them. To determine the management fees, the Company's actual costs plus a small margin were distributed amongst these entities on the basis of a percentage of these entities' net profits before management fee and taxation. In the mid-1990s, the corporate trustee of the Discretionary Trust acquired the Commercial Property with a loan for a significant portion of the acquisition price from a financial institution and an inter-group loan for the balance. The Commercial Property was leased to a company at an agreed annual rent, which was later increased after certain freehold improvements were made. From the first quarter of the relevant income year, the Commercial Property was leased to the Company under a six-month lease at an agreed annual rent (which was higher than the previous rental arrangement). The Company operated the Commercial Property as a business. During the second quarter of the relevant income year a custodian company (the Custodian) acquired the Commercial Property, which was on a single title, from the corporate trustee of the Discretionary Trust with funds provided by the Fund Trustee at that time, and holds the legal title of the Commercial Property on trust for the Fund Trustee. The funds needed were provided through the Fund's own resources and a loan obtained from the corporate trustee of the Discretionary Trust. Under this custody-trust arrangement, the Fund Trustee acquired, on behalf of the Fund, a beneficial interest in the freehold of the Commercial Property. The Fund Trustee will have a right to acquire legal ownership of the Commercial Property after re-paying the corporate trustee of the Discretionary Trust, in several years' time, the amount borrowed. The acquisition price was based on a valuation report prepared by a property valuer (the Property Valuer) in the third quarter of the prior income year. The valuation report was originally prepared on behalf of a financial institution in relation to loans made by the financial institution to the corporate trustee of Unit Trust 1. While the Commercial Property was sold by the corporate trustee of the Discretionary Trust to the Fund Trustee for an amount that well exceeded its acquisition cost, the prior year balance sheet of the Discretionary Trust, however, shows a negative "Motel Revaluation" of a substantial amount, which grossly reduces the book value of the Commercial Property. According to the applicant of this private ruling (the Applicant), the financial statements of the Discretionary Trust for the relevant income year has not yet been completed and this negative revaluation will be reversed in order to correctly determine the capital gain or loss made by the Discretionary Trust on disposal of the Commercial Property in accordance with the relevant legislation. In relation to the loan obtained by the Fund Trustee from the corporate trustee of the Discretionary Trust, the only security given was a first mortgage over the Commercial Property. No personal guarantees have been provided. The loan amount was, according to the Applicant, in line with certain guidelines on the maximum loan size for commercial property and the lending-value ratio, purportedly obtained from a financial institution. According to the Fund's prior year balance sheet, its total assets consisted mainly of a term deposit with a financial institution. The Fund paid the balance of the acquisition price of the Commercial Property out of its own resources, which amounted to more than X% of the Fund's total assets. A loan agreement between the Fund Trustee (the Borrower) and the corporate trustee of the Discretionary Trust (the Lender) provides for the following: · what the Borrower may do with the loan; · how interest is calculated and paid; · when the Borrower must repay the loan; · how the Borrower may repay the loan; · what security the Borrower must provide; · limited recourse for the Lender's right against the Borrower; · when the Lender will release the security; · what the Lender may do if a default occurs. When asked by the Australian Taxation Office (the ATO) for an explanation of how the borrowing by the Fund Trustee from the corporate trustee of the Discretionary Trust was in compliance with the requirements of the Superannuation Industry (Supervision) Act 1993, the Applicant responded as follows: · Specifically, the borrowing was in accordance with section 67A of the Superannuation Industry (Supervision) Act 1993 (the SIS Act), which provides an exception to the general prohibition against borrowings in section 67 of the SIS Act. That is, the borrowings were: a. in accordance with section 67A(1)(a) in that they were only applied to the acquisition of a single acquirable asset; b. …section 67A(1)(b) in that the single acquirable asset is held by [the Custodian] under a custodian trust for the Fund beneficially; c. …section 67A(1)(c) in that the Fund has the right to acquire legal title to the asset under the terms of the custodian trust; d. …section 67A(1)(d) in that the rights of the lender, [the corporate trustee of the Discretionary Trust], [as against the Fund Trustee] are limited to recourse only to the asset acquired; e. …section 67A(1)(e) in that the rights of the lender [the corporate trustee of the Discretionary Trust] as trustee for [the Discretionary Trust], and [the Custodian] as trustee of the custody trust, [as against the Fund Trustee] are limited to recourse only to [rights relating to] the acquired asset; f. …section 67A(1)(f) in that the mortgage on the property is in accordance with the terms of section 67A(1)(d); g. …section 67A(2) in that the asset acquired is real estate, not money, and there are no laws prohibiting the Fund from acquiring the asset. The legal title to the Commercial Property is held by the Custodian pursuant to a 'Declaration of Custody Trust for the Fund' which states, among other things, that: · the Custodian will hold the benefit of the custody fund on trust for the Fund Trustee; · the parties agree that the trust is established and is to be maintained in connection with the limited recourse borrowing arrangement with the lender; · the Fund Trustee will provide to the Custodian all funds necessary to enable the Custodian to purchase the Authorised Investment; · the Fund Trustee must designate one or more bank accounts of the Fund into which amounts may be deposited by the Custodian; · the Fund Trustee has a vested and indefeasible interest in the Authorised Investment and any other assets comprising the custody fund; and · the Custodian must execute all documents the Fund Trustee asks it to execute that are necessary to charge the Authorised Investment to secure the Fund Trustee's payment to the lender of all money owed in respect of the Authorised Investment. The agreed rent payable by the Company to the corporate trustee of the Discretionary Trust for leasing the Commercial Property under the six month lease was based on the valuation report prepared by the Property Valuer In their valuation report on the Commercial Property, the Property Valuer assessed the leasehold value of the Commercial Property on a going-concern basis. Based on an appropriate term of lease having regard to the industry practice in the relevant State, the corporate trustee of the Discretionary Trust increased the rent payable by the Company per year to take into account the short duration of the lease. After the acquisition, the Commercial Property continue to be leased to the Company on a month-to-month basis and the Fund Trustee, which now holds a beneficial interest in the Commercial Property on behalf of the Fund, receives rent from the Company. Some time in 20XX, representatives of a management company (the Management Company) that operates properties similar to the Commercial Property, met Member A. Subsequently in a letter to Member A, the Management Company proposed to manage the Commercial Property and a commercial property owned by Unit Trust 2 in return for a management fee that would, for an initial term of a specified number of years, comprise: (a) a base fee based on a specified percentage of total property revenue; and (b) performance fee based on a specified percentage of gross operating profit plus another specified percentage of any increase in gross operating profit over the same period of the previous year. The Management Company's proposal was, however, not taken up. What the Fund Trustee intends to do is to terminate the month-to-month lease with the Company and to appoint the Company as the manager of the Commercial Property instead. The effect of this appointment is that: (a) the Company will no longer, as a tenant: (i) operate the Commercial Property as a business in its own right; and (ii) pay rent to the freehold owner of the Commercial Property under a lease; (b) the Company will, as the manager of the Commercial Property: (i) manage and operate the Commercial Property on behalf of the freehold owner of the Commercial Property; and (ii) pass on any profit that may be derived from the operation to the freehold owner of the Commercial Property; and (c) the freehold owner of the Commercial Property will pay the Company a management fee. As the manager of the Commercial Property, the Company will: (a) in operating the business, enter into contractual relationships with customers, suppliers and employees; (b) maintain a business bank account and remit net goods and services tax from sales and pay-as-you-go withholdings from employees; (c) manage any maintenance and capital-work expenditure on behalf of the freehold owner, engaging consultants, contractors and others to perform the work required; and (d) on a quarterly basis, calculate, and pay to the Fund, any profit being the difference between the operation's sale receipts and operating expenses. In their letter to the ATO, the Applicant advised that to have employees for the operation of the Commercial Property being engaged by the Company rather than by the freehold owner and to have bank and trade accounts for the operation of the Commercial Property in the Company's name, rather than the freehold owner's, are to reduce the freehold owner's involvement in the business so its role is that of a passive investor. In relation to the appointment, a management agreement (the Proposed Agreement) between the Fund Trustee as 'the Owner', the Company as 'the Manager' and the Custodian as 'the Third Party' has been drafted. Closely following the wording of the model management agreement provided by the Management Company, the Proposed Agreement adopts the essential terms and conditions offered by the Management Company, especially in respect of: (a) the manner in which management fee is to be calculated; (b) the Manager's responsibilities; and (c) what constitute 'operating expenses' and 'revenue'. Among other things, the Proposed Agreement states that: · the Owner will pay to the Manager the Management Fee calculated from the Management Commencement Date; · the Manager is responsible for the proper operations, direction, management and supervision of the Commercial Property; · the Manager must keep full and adequate books of accounts and such other records as are necessary to reflect the results of the operation of the Commercial Property; · all employees engaged by the Manager in operating the Commercial Property including the Executive Staff will be employed by the Manager; · the Manager must maintain the Account at a financial institution of its choice and pay into that account all Revenue; · all funds and other moneys received by the Manager in the operation of the Commercial Property will be deposited into the Account; · funds are not to be mingled with the Manager's other funds; · the Manager will be entitled to pay from the Account various expenses specified in the Proposed Agreement; and · the Manager will secure and maintain all insurance with respect to the Commercial Property. The initial and further terms of the Proposed Agreement, as well as the base and incentive fees, are all specified in a schedule to the Proposed Agreement. In the second quarter of the relevant income year the Applicant, on behalf of the Fund Trustee, requested the ATO for a self managed superannuation fund (SMSF) specific advice on whether the proposed arrangement outlined above will result in a contravention of the sole-purpose test by the corporate trustee of the Fund under section 62 of the Superannuation Industry (Supervision) Act 1993 and/or the Superannuation Industry (Supervision) Regulations 1994. According to the Applicant, in that request they advised the ATO that: (a) the Company would operate the business on behalf of the freehold owner and receive a mark-up on expenditure as its financial return for undertaking that role; and (b) the mark-up would be determined having regard to the guidelines contained in 'Your service entity arrangements' published by the ATO. This mark-up proposal was subsequently replaced by a management fee modelled on that proposed by the Management Company. In the private-ruling application, the Applicant provided the following reason for the change: We were not aware of the specific proposal from [the Management Company] to our client at the time the request for advice was made. It is submitted that it was always the taxpayer's intention to ensure that the basis of charging fees between entities was acceptable to the Commissioner. At the time of the submission it was considered that the 'mark-up on costs' method set out in that publication [of the ATO's] was, in the absence of a market-based alternative, the basis of charging fees which would be most acceptable to the Commissioner. The publication, however, clearly indicates that [the] most acceptable basis of charging fees is that which would be applicable if payment for the services were provided at market rates. The SMSF specific advice given by the Commissioner (in his role as the Regulator of SMSF) was that the proposed arrangement will not, of itself, result in a contravention, although 'carrying on a business', 'in-house assets' and non-arm's length income' are issues which the corporate trustee of the Fund should consider. Projected income of the Fund for the 2011-12, 2012-13 and 2013-14 income years has been provided to the ATO, on the basis of both: (a) the Fund being the Lessor, and the Company as Lessee, of the Commercial Property (as is currently the case); and (b) the Fund as the Owner, and the Company as the Manager, of the Commercial Property (as will be the case under the proposed management arrangement). The figures provided show the projected income of the Fund for the subsequent income year under the proposed management arrangement, will more than double what the Fund may derive as the Lessor. This will further rise to almost Y times for the 2012-13 income year and to over Z times for the 2013-14 income year. Projected income of the Company for the 2011-12, 2012-13 and 2013-14 income years has been provided to the ATO, also on the basis of both: the Fund being the Lessor, and the Company as Lessee, of the Commercial Property (as is currently the case); and the Fund as the Owner, and the Company as the Manager, of the Commercial Property (as will be the case under the proposed management arrangement). As the figures provided show, the projected income of the Company for the subsequent income year under the proposed management arrangement will be approximately X% of what the Company may derive as the Lessee. This will further drop to around Y% for the 2012-13 income year and to almost Z% for the 2013-14 income year.

Relevant legislative provisions: Income Tax Assessment Act 1936 Section 109N | Income Tax Assessment Act 1997 Section 295-545 | Income Tax Assessment Act 1997 Section 295-550 | Income Tax Assessment Act 1997 Subsection 295-550(1) | Superannuation Industry (Supervision) Act 1993 Section 62 | Superannuation Industry (Supervision) Act 1993 Section 67A Summary of decision | Income to be derived by the Fund from the operation of the Commercial Property by the Company as the Manager on behalf of the Fund Trustee will not be non-arm's length income of the Fund because there is no indication that: | (a) the parties involved have not been dealing with each other at arm's length; and | (b) the income to be so derived is more than what the Fund might have been expected to derive if the parties involved had been dealing with each other at arm's length. | Detailed reasoning | Non-arm's length income | In accordance with section 295-545 of the Income Tax Assessment Act 1997 (the ITAA 1997, the taxable income of a complying superannuation fund is split into a 'non-arm's length component' and a 'low tax component'. The non-arm's length component for any income year is the fund's non-arm's length income for that year, less any deductions to the extent that the deductions are attributable to that income, and is then taxed at the highest marginal rate (currently 45%). | The remaining part of the fund's taxable income for the income year is the low tax component, which is taxed at a concessional rate (currently 15%). | Pursuant to subsection 295-550(1) of the ITAA 1997, an amount of ordinary income or statutory income is non-arm's length income of a complying superannuation fund if the amount: | (a) 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) is more than the amount that 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. | Income derived from scheme | 'Scheme' and 'arrangement' are defined in subsection 995-1(1) of the ITAA 1997 as follows: | scheme means: | (a) any arrangement; or | (b) any scheme, plan, proposal, action, course of action or course of conduct, whether unilateral or otherwise. | 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. | A scheme may comprise the whole of an agreement, arrangement, etc or one or more steps within the arrangement. The following statement was made by the High Court in the context of Part IVA of the ITAA 1936 which defines 'scheme' in comparable terms; | Th[e] definition is very broad. It encompasses not only a series of steps which together can be said to constitute a "scheme'' or a "plan'' but also (by its reference to "action'' in the singular) the taking of but one step. | The Federal Court in Allen (As Trustee of the Allen's Asphalt Staff Superannuation Fund) v. Federal Commissioner of Taxation 1 (Allen) considered the former section 273 of the ITAA 1936, which was the predecessor to section 295-550 of the ITAA 1997. Though referring to 'special income' rather than non-arm's length income, section 273 of the ITAA 1936 was of similar effect to section 295-550 of the ITAA 1997. Likewise, subsection 273(8) of the ITAA 1936 defined 'arrangement' to incorporate substantially the same terms as 'scheme' in section 295-550 of the ITAA 1997. | The Federal Court found in Allen that, since 'arrangement' was defined widely, there was no justification to interpret the steps which constitute an arrangement narrowly. The Court also held that a liberal interpretation of 'arrangement' was supported by the Explanatory Memorandum for the Superannuation Legislation Amendment Bill (No. 2) 1999 which introduced subsection 273(8). Justice Collier said: | … Indeed the width of the definition of "arrangement" in s 273(8) specifically militates against a narrow interpretation, in that s 273(8) clearly contemplates understandings beyond legally enforceable agreements or instrument... 2 | … The width of the definition of "arrangement" is such that an arrangement may come into being by a sequence of interconnected steps, including, at various stages, incorporation of companies or declaration of trusts. Where the alleged arrangement is characterised by a series of steps it is necessary that the steps be co-ordinated in anticipation of achieving a goal to fall within the definition of "arrangement" in s 273(8), rather than be random steps with no structure or pattern… | Thus, a scheme from which an amount of income is derived by a fund may comprise a series of interrelated steps, extending beyond a legally enforceable formal agreement, to encompass an informal understanding between the parties. | In our view the steps taken by the parties involved, which culminate in the Company operating the Commercial Property on behalf of the Fund Trustee for a bigger return to the Fund, are tantamount to a scheme as is defined in subsection 995-1(1) of the ITAA 1997 and as is referred to in subsection 295-550(1). These steps were: | (a) During the last quarter of the prior income year the Property Valuer prepared a valuation report for the Commercial Property on behalf of a financial institution in relation to the loans made by the financial institution to facilitate the purchase of a business by the corporate trustee of Unit Trust 1. The valuation report was later used as the basis for determining the price at which the Custodian acquired the Commercial Property on behalf of the Fund. | (b) Prior to the first quarter of the relevant income year, the corporate trustee of the Discretionary Trust had leased the Commercial Property to another company. During that quarter it leased the Commercial Property to the Company under a six-month lease. The Company operated the Commercial Property as a business in its own right. | (c) After their representatives met Member A some time in 20XX, the Management Company proposed, in a letter to Member A, to manage the Commercial Property and a commercial property owned by Unit Trust 2. | (d) In the second quarter of the relevant income year, the Custodian acquired the Commercial Property from the corporate trustee of the Discretionary Trust, using funds provided by the Fund Trustee, which included a loan to the Fund Trustee by the corporate trustee of the Discretionary Trust. The Custodian holds the legal title of the Commercial Property on trust for the Fund Trustee. | (e) After the acquisition of the Commercial Property by the Custodian, the Commercial Property continues to be leased to the Company on a month-to-month basis. | (f) The Management Company's proposal to manage the Commercial Property and the commercial property owned by Unit Trust 2 was not taken up. Instead, the Fund Trustee intends to terminate the month-to-month lease of the Commercial Property with the Company and to appoint the Company as the manager of the Commercial Property. This will change the Company's role from being a tenant of the Commercial Property who operates the Commercial Property as a business and pays rent to the freehold owner of the Commercial Property to that of a manager who, in return for a management fee, will manage and operate the Commercial Property on behalf of the freehold owner of the Commercial Property and will pass on any profit that may be derived from the operation to the freehold owner of the Commercial Property. | (g) Under the Proposed Agreement between the Company and the freehold owner of the Commercial Property: | (i) employees for the operation of the Commercial Property will be engaged by the Company rather than the freehold owner; and | (ii) the bank and trade accounts for the operation of the Commercial Property will be in the Company's name rather than in the name of the freehold owner | so the freehold owner's role is that of a passive investor. | Whether parties to scheme were not dealing with each other at arm's length | The term '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. | At all material times, Member A and Member B, who are the sole members of the Fund, are also: | (a) the sole directors and shareholders of the Fund Trustee; | (b) the principal beneficiaries of the Discretionary Trust, which is controlled by Member A as the sole director and the company secretary of its corporate trustee, and which previously owned the Commercial Property; and | (c) the equal shareholders of the Company, which the Fund Trustee intends to engage as Manager of the Commercial Property. | In addition, Member A is the sole director and the company secretary of the Company. | In view of their close relationship, the Fund Trustee, the corporate trustee of the Discretionary Trust and the Company are non-arm's length parties in relation to the proposed operation of the Commercial Property by the Company as the Manager on behalf of the Fund Trustee. | Although the nature of the relationship between parties is relevant in determining whether dealings between them are at arm's length, parties that are not at arm's length can still deal with each other at arm's length in relation to a particular dealing. | The Commissioner has issued Taxation Ruling TR 2006/7 entitled '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'. This ruling explains what amounts are considered to be 'special income' under the former section 273 of the ITAA 1936 and, as the wording of section 273 of the ITAA 1936 is similar to section 295-550 of the ITAA 1997, may also assist in the interpretation of section 295-550 of the ITAA 1997. | Paragraph 76 of TR 2006/7 states that: | 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. | This view is based on the decisions in Re Hains; Barnsdall v. Federal Commissioner of Taxation 3 ; Trustee for Estate of AW Furse No 5 Will Trust v. Federal Commissioner of Taxation 4 ; and Granby Pty Ltd v. Commissioner of Taxation 5 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, 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'. | The dealings between the Fund Trustee, the corporate trustee of the Discretionary Trust and the Company involve: | (a) the provision of a fixed-term loan by the corporate trustee of the Discretionary Trust to the Fund Trustee to fund a major part of the consideration paid by the Fund for the acquisition of the Commercial Property; | (b) the provision of a first-ranking mortgage or charge over the Commercial Property as security for the borrowing by the Fund Trustee as the borrower to the corporate trustee of the Discretionary Trust as the lender; | (c) the adoption, by the Fund Trustee and the corporate trustee of the Discretionary Trust, of the benchmark interest rate stipulated in subsection 109N(2) of the ITAA 1936 as the interest rate at which interest is payable by the Fund to the Discretionary Trust on the loan provided by the latter; | (d) the acquisition of the Commercial Property by the Custodian on behalf of the Fund Trustee from the corporate trustee of the Discretionary Trust in the second quarter of the relevant income year, based on the valuation report prepared by the Property Valuer in the third quarter of the prior income year; | (e) the agreement by the corporate trustee of the Discretionary Trust to lease the Commercial Property to the Company for six months from a date in the first quarter of the relevant income year (i.e. prior to the acquisition of the Commercial Property by the Custodian on behalf of the Fund Trustee) at an agreed annual rent, based on the valuation report prepared by the Property Valuer and adjusted upward because of the short duration of the lease; and | (f) the adoption, by the Fund Trustee and the Company, of the Management Company's rates of base fee and incentive fee as the method for calculating the management fee payable by the Fund Trustee to the Company as the latter's remuneration for operating the Commercial Property on behalf of the Fund Trustee. | From the information provided, we have noted that: | (a) the Fund pays interest to the Discretionary Trust on the loan at the benchmark interest rate stipulated in subsection 109N(2) of the ITAA 1936, which is one of the conditions under subsection 109N(1) that must be met if a loan by a private company to an entity is not to be taken as a dividend from the private company to the entity; | (b) as the loan represented just over half of the acquisition price only, the Fund had to meet the balance of the acquisition price out of its own resources, which amounted to more than half of the Fund's total assets, thereby locking in substantial funds which might otherwise be invested elsewhere, as well as assuming risks inherent in any investment, such as risk of a fall in the market value of the Commercial Property and risk of interest-rate rises; | (c) the fixed-term loan is well below the maximum term of 25 years permitted under subsection 109N(3) of the ITAA 1936 as one of the conditions to be met for a loan made by a private company to an entity not to be taken as a dividend from the private company to the entity; | (d) the acquisition price at which the Commercial Property were acquired was based on a valuation report prepared by a professional valuer; | (e) the rent payable by the Company under the short-term lease between the corporate trustee of the Discretionary Trust (or the Fund Trustee after the Commercial Property was acquired by the Custodian on behalf of the Fund Trustee) and the Company was, again, based the valuation report with an upward adjustment to compensate for the short duration of the lease; and | (f) the Fund Trustee would have paid the same amount of management fee to the Management Company had the latter (and not the Company) been appointed as the Manager to operate the Commercial Property on behalf of the Fund Trustee. | We have also considered the submissions made by the Applicant on behalf of the Fund Trustee in relation to the aforementioned dealings. We accept that, based on the information provided, there is no indication of the parties involved in any of the aforementioned dealings not dealing with each other at arm's length. | Amount derived is greater than what might have been derived on arm's length basis | Paragraphs 79 and 80 of TR 2006/7 state that: | 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 6 Justice Gyles of the Federal Court, when 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 arm's 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. | As noted before, the Fund will achieve a much greater return from its investment in the Commercial Property if the Company operates the Commercial Property as the Manager on behalf of the Fund Trustee than if the Company operates the Commercial Property in its own right as a lessee. On the other hand, the Company will achieve a much smaller return when it operates the Commercial Property as the Manager on behalf of the Fund than when it operates the Commercial Property in its own right as a tenant. | On the face of things, there appears to be a huge amount of income being shifted from the Company to the Fund under the proposed management arrangement. This calls into question as to whether the amount being shifted is more than the amount that the Fund might have been expected to derive if the Fund Trustee and the Company had been dealing with each other at arm's length in relation to the proposed management arrangement. With a view to tackling this perception, the Applicant has made the following submissions: | (a) That is, the arrangements proposed are sufficiently similar to those which would be in place if [the Management Company] were appointed as the Manager to be considered those which would be in place if the parties were acting at arm's length. The financial arrangements proposed for payment to [the Company] are identical to the proposal made by [the Management Company] to our client and the agreement which documents the arrangements is very similar to the document proposed by [the Management Company] to our client. | (b) The differences of significance between the agreement proposed and [the Management Company's] document have been made to reduce the freehold owner's involvement in the business so its role is that of a passive investor. We submit that the arrangements proposed are more appropriate for a superannuation fund which owns such a property, notwithstanding that it is lawful for a superannuation fund to actually operate the business. | (c) …We submit that the amount of income which would be earned by the Fund is identical to that which would have been earned had [the Management Company] been selected as manager. | (d) It is further submitted that the termination of the current lease by which [the Company] operates [the Commercial Property] and its replacement with the proposed management agreement should not be considered as a scheme to which section 295-550 should apply. | (e) …Its [the Management Company's] proposal to our client in respect of the properties in question was considered by them the most appropriate indicator of an arm's length arrangement between the owner of [the Commercial Property] and a management company. | (f) Firstly, it is apparent that the financial return to the Fund from the proposed arrangement is higher than that resulting from the continued lease of the property to [the Company]. The trustees [of the Fund] consider part of their obligations as trustees is to maximise the Fund's returns within an acceptable level of risk. | (g) We submit that the mere fact that the return to the Fund will be higher than it currently enjoys is not a matter to be considered adversely by the Commissioner. We submit that the critical issue in evaluation the proposed arrangement is whether the return the Fund will derive from the proposed arrangements is more than the Fund would have derive if an arm's length party were the manager. We have provided evidence that the Fund would derive the same income if the arm's length party, [the Management Company], were appointed manager compared to the proposal involving [the Company]… | (h) Secondly, our client has asked that we provide an explanation of why the Fund trustees prefer [the Company] to provide the management services to the Fund rather than [the Management Company]. Although the cost would be the same the trustees [of the Fund] have known and assisted in the training of [the Company's] employees over a twenty-year period. This means that the trustees have confidence that the systems and procedures which have been developed over that period will continue and this reduces the risk associated with the operation of the business… | It is open to the Fund Trustee to make any investment decision that may optimise investment return for the Fund, as long as in making the decision the Fund Trustee acts in the best interests of the members of the Fund and does not contravene the SIS Act or breach its duties under the trust deed of the Fund. Within such constraint, the Fund Trustee may choose to: (a) rent the Commercial Property out to a particular tenant (not necessarily the Company) and receive rent from the latter as investment income; or | (b) appoint a particular party to operate the Commercial Property on its behalf and receive any profit that the operation may generate, provided that in so doing the Fund Trustee still meets the sole purpose test required of a regulated superannuation fund under section 62 of the SIS Act and does not breach any trust law. Rent under a lease is usually a fixed and relatively stable income, whereas profit from operating a property as the Commercial Property may fluctuate due to a number of factors, notably the quality of management, prevailing market conditions and the state of the economy. We accept that it is up to the Fund Trustee to choose either way in accordance with the Fund's investment strategy and be prepared to accept any risks that come with the choice. | Where the Fund Trustee chooses to appoint a particular party to operate the Commercial Property on its behalf, the party being chosen is usually one which the Fund Trustee considers to be most appropriate for the operation, having regard to that party's knowledge, experience, reliability and efficiency and to the terms and conditions offered by that party, as long as the Fund Trustee and that party are dealing with each other at arm's length. | When the Commercial Property were still owned by the corporate trustee of the Discretionary Trust, the Company was the 'head-office' company, which provided management support to the Discretionary Trust (and other entities). There is no indication that the Management Company is more suitable than the Company in operating the Commercial Property as the Manager thereof. | We accept the Applicant's submission that the amount of income which would be earned by the Fund by having the Company operate the Commercial Property as the Manager is identical to that which would have been earned had the Management Company been selected as the Manager. | We also concur with the Applicant that in determining whether the income derived by the Fund from the operation of the Commercial Property by the Company as the Manager is non-arm's length income of the Fund, the crucial issue is not whether the Fund will thereby derive a larger amount of income, but whether the Fund and the Manager are dealing with each other at arm's length, whoever that Manager is. | Conclusion | To conclude, we are of the view that the income to be derived by the Fund by having the Company operate the Commercial Property as the Manager on behalf of the Fund Trustee will not be non-arm's length income of the Fund under section 295-550 of the ITAA 1997