Private ruling: Limited recourse borrowing arrangement and non-arm's length income
Published: August 2014
Ruling period: Year ending 30 June 2014
Date scheme commenced: 1 July 2013

Ruling: Q1: If the self-managed superannuation fund enters into a limited recourse borrowing arrangement at a below market value rate of interest or zero rate of interest will this give rise to non-arm's length income? Advice/Answers Yes.

Relevant facts and circumstances: The Fund is a complying self-managed superannuation fund. The Fund was established in the late 1990s. The members of the Fund (the Members) are married to each other. The corporate trustee of the Fund (the Fund Trustee), was incorporated and became the trustee of the Fund in the 2013-14 income year. The Members are the directors of the Fund Trustee. The Fund purchased freehold property (the Property). The Property is used in a business and was acquired from an unrelated party. The Members have acquired the business in their own names and will be conducting the business through a partnership (the Partnership) of which they are partners. As part of the purchase, a lease agreement for the rental of the freehold was assigned across to the Fund (as lessor) and the Partnership (as lessee). This lease agreement expires in the 2015-16 income year. As per the lease agreement, the rent is reviewed on each anniversary of the commencement date. The rent review method selected was the consumer price index (CPI) method. The Members have sought confirmation that the current level of leasing income is an appropriate market value level. In a Letter of Agents Opinion of Value a real estate agent has given an estimate of the value of the land and buildings together with an estimate of the value of a reasonable rent. In the 2013-14 income year a limited course borrowing arrangement (the Loan Agreement) for the Property was entered into between: • the Members as the lenders; and • the Fund Trustee as the borrower. A holding company will hold the Property in a bare trust for the Fund. The Members are the directors of the holding company. The Fund Trustee has currently borrowed an amount for a term of over 10 years. The term of the loan may be varied with the consent of both the Lender and the Borrower. The initial interest rate is variable and payable in arrears. The loan is interest only for the first few years with the ability by the Fund to make capital repayments during this time. The Members have agreed to advance and the Fund has agreed to borrow and accept a maximum amount not exceeding a predetermined facility amount subject to the terms and conditions of the Loan Agreement. The Fund may draw down amounts up to the facility amount subject to the money being applied for the acquisition, maintenance or repair of the Property. There may be multiple drawdowns and they may occur over a period of time. Further, the Members as the lender may increase the facility amount at its discretion. The Members rights as lenders against the Fund as the borrower in respect of the loan are limited to rights relating to the asset only. The lender may take a mortgage, charge or any type of security over the asset. The lender confirms that the total amount outstanding is not otherwise secured by or against the borrower. The Members are currently considering varying the terms of the interest payable under the loan to either a below market value rate of interest or zero rate of interest.

Relevant legislative provisions: Income Tax Assessment Act 1997 Section 295-550. | Income Tax Assessment Act 1997 Section 295-545. | Income Tax Assessment Act 1997 Subsection 995-1(1). Further issues for you to consider | Not applicable. | Anti-avoidance rules | Not applicable.

Reasons for decision: Summary: The discount of interest to the market rates will be non-arm's length income of the Fund. | Detailed Reasoning - Non-arm's length income: Section 295-545 of the Income Tax Assessment Act 1997 (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. Subsection 295-545(2) of the ITAA 1997 provides that the non-arm's length component for an income year is the entity's non-arm's length income for that year less any deductions to the extent that they are attributable to that income. The phrase 'non-arm's length income' has the meaning given by section 295-550. Subsection 295-550(1) provides that: 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 . | Detailed Reasoning - Not dealing at arm's length: Subsection 995-1(1) of the ITAA 1997 provides that in determining whether parties deal at arm's length, consider any connection between them and any other relevant circumstances. In Federal Commissioner of Taxation v AXA Asia Pacific Holdings Ltd Justice Dowsett of the Full Federal Court 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; • un-related 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 Justices Edmonds and Gordon further stated 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': … It is clear that the parties in this case are not in an arm's length relationship. The Fund is a self-managed superannuation fund and the members of the Fund are married to each other. The Fund purchased the Property from an unrelated party. As noted earlier, the Members have acquired the business in their own names and will be conducting the business using the Property through a partnership (the Partnership) of which they are equal partners. As part of the purchase, a lease agreement for the rental of the Property was assigned across to the Fund (as lessor) and the Partnership (as lessee). In the 2013-14 income year a limited course borrowing arrangement for the Property was entered into between the Members (the Lender) and the Fund Trustee (the Borrower). The Property will be held in a bare trust for the Fund. The Members are the directors of the bare trustee. The Fund Trustee has currently borrowed an amount for a term in excess of 10 years. The term of the loan may be varied with the consent of both the Lender and the Borrower. The initial interest rate is variable and payable in arrears. The loan is interest only for the first few years with the ability to make capital repayments during this time. The Members have agreed to advance and the Fund has agreed to borrow and accept a maximum amount not exceeding a predetermined facility amount subject to the terms and conditions of the Loan Agreement. The Fund may draw down amounts up to the facility amount subject to the money being applied for the acquisition, maintenance or repair of the Property as contemplated by section 67(1)(a) of the SIS Act. There may be multiple drawdowns and they may occur over a period of time. Further, the Members as the lender may increase the facility amount at its discretion. The Members rights as lenders against the Fund as the borrower in respect of the loan are limited to rights relating to the asset only. The lender may take a mortgage, charge or any type of security over the asset. The lender confirms that the total amount outstanding is not otherwise secured by or against the borrower. The Members are currently considering varying the terms of the interest payable under the loan to either a below market value rate of interest or a zero rate of interest. Assessing the circumstances holistically, it is clear that the parties will not be dealing with each other in respect of the limited recourse borrowing arrangement as arm's length parties would do. Aspects which, taken together, the Commissioner considers lead to that conclusion include: • the lender is not, by way of charging below market value rate of interest or a zero rate of interest under the loan, compensated adequately for the risk assumed in relation to recovery of the principal in the event of the borrower's default; • no security required by the lender for the loan; and • the absence of protection mechanisms given the limited recourse nature of the loan, lack of other security, and the risk involved in investing in the Property. | Detailed Reasoning - Amount of income greater than might be expected if dealing at arm's length: The final requirement is that the amount 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. If the parties in this case were dealing with each other at arm's length, the Fund might be expected to: • pay a higher level of interest reflective of the risk faced by the lender; and/or • require security for the loan arrangement. | Detailed Reasoning - Conclusion: As such, the discount of interest to the market rates will be non-arm's length income of the Fund pursuant to subsection 295-550(5) of the ITAA 1997. | Detailed Reasoning - Legislative intent: This conclusion is entirely consistent with the legislative intent of section 295-550 of the ITAA 1997 and its predecessors. Section 295-550's earliest predecessor - former section 23F of the ITAA 1936 - was introduced in 1964 as a result of the Report of the Commonwealth Committee on Taxation, 1961 (Ligertwood Report) which recommended legislative amendments to counter the numerous ways identified by the Committee in which a taxpayer could constitute a superannuation fund with income, that would have accrued to the taxpayer in the ordinary course of events, and thus be received virtually tax free. Of particular relevance to the circumstances of this case was the second example given in the Ligertwood Report of a situation which the recommended legislation was to address: A director-controlled superannuation fund is set up by a private company, primarily for the benefit of those employees who are also shareholders and directors. The directors then cause the company to make interest-free loans to the fund which invests the proceeds. The income derived by the fund from its investments is exempt under Section 23(j) and when this income is eventually paid to the directors in a lump sum on their retirement, only 5 per cent thereof will be taxed in the hands of the beneficiaries or alternatively the amount may be wholly free from tax. Further, the Full Federal Court in Darrelen Pty Ltd v Federal Commissioner of Taxation stated that: … the policy underlying s 273, and its predecessors, is to enable the Commissioner to deny the concessional taxation of income which has been diverted from taxpayers not enjoying that status. Similarly, the Explanatory Memorandum accompanying the Bill which inserted former subsections 273(6) and (7) of the ITAA 1936 - the immediate predecessors of subsections 295-550(4) and (5) of the ITAA 1997 - explained that: … section 273 is designed to prevent income from being unduly diverted into superannuation entities as a means of sheltering that income from the normal rates of tax applying to other entities, particularly the marginal rates applying to individual taxpayers. The main effect of the scheme in this case, being the movement of income producing capital through a non-arm's length dealing from entities who would pay marginal or company tax rates on such income into the concessionally taxed superannuation fund is clearly intended to be addressed by section 295-550 of the ITAA 1997 and its predecessors.