Private ruling: Non-arm's length income
Published: November 2014
Ruling period: Income year ending 30 June 2016
Date scheme commenced: 17 January 2014

Ruling: Q1: 1. Will any income derived by a superannuation fund (the Fund) from its beneficial ownership of a commercial building be non-arm's length income of the Fund if the interest rate of a loan (the Loan), which already exists, is reduced to 0%? 2. Will the difference between the existing interest rate and the reduced interest rate of 0% be considered a contribution to the Fund? | A1: 1. Yes. 2. No.

Relevant facts and circumstances: The Fund is a self-managed superannuation fund. The Fund has two members (Member 1 and Member 2. The trustees of the Fund (the Fund Trustee) are Member 1 and Member 2. In the 2013-14 income year, the Fund Trustee purchased a commercial property (the Property) from an unrelated party. The purchase of the Property was funded partly by a loan (the Loan) from a related private company (the Lender) as trustee for a family trust (the Lending Trust). Member 1 is the director of the Lender. The primary beneficiaries of the Lending Trust are Member 1 and Member 2, and their children and grandchildren. A loan agreement (the Loan Agreement) executed between the Fund Trustee and the Lender relevantly provides that: • the Borrower must pay to the Lender the Repayments on each Payment Date during the Term; • Repayments means the repayments of the principal and payment of interest under the agreement; • the Repayment Date means the 15 th anniversary of the Settlement Date; • the Payments Dates are the last day of each calendar month; • Interest means Reserve Bank of Australia Rate plus an agreed percentage and • Loan may be amended, supplemented, novated or replaced by another document signed by the parties. The Lender intends to reduce the interest rate on the Loan to 0%. The Property is held on trust for the Fund Trustee by a related bare trust (the Custody Trust). Member 1 and Member 2 are directors and members of the trustee of the Custody Trust (the Custodian). In accordance with a deed of trust (the Custody Deed) executed by the Fund Trustee and the Custodian: • The Custodian holds the benefit of the 'Custody Fund' on trust for the Fund Trustee. • Custody Fund' is defined in the Custody Deed as: (a) all right, title and interest of the Custodian from time to time in the Property; (b) all income and other proceeds generated from the holding of the Property; and (c) any other amounts which accrue to the Custodian from time to time. • The Fund Trustee has a vested and indefeasible interest in Property and any other assets of the Custody Trust; and is absolutely entitled to the Property and other asset as against the Custodian. • The Fund Trustee may direct the Custodian to transfer, or otherwise deal with, the Property and other assets comprising the Custody Fund. The Custodian must do as directed. • Before the Custodian transfers, or otherwise deals with, the Property and other assets comprising the Custody Fund, the Custodian must first seek consent from the Fund Trustee.

Relevant legislative provisions: Income Tax Assessment Act 1997 Section 295-545 | Income Tax Assessment Act 1997 Subsection 295-545(1) | Income Tax Assessment Act 1997 Subsection 295-545(2) | Income Tax Assessment Act 1997 Section 295-550 | Income Tax Assessment Act 1997 Subsection 295-550(1) | Income Tax Assessment Act 1997 Subsections 295-550(4) | Income Tax Assessment Act 1997 Subsections 295-550(5) | Income Tax Assessment Act 1997 Paragraph 295-550(5)(a) | Income Tax Assessment Act 1997 Paragraph 295-550(5)(b) | Income Tax Assessment Act 1997 Subsection 995-1(1) | Income Tax Assessment Act 1936 Section 23F | Income Tax Assessment Act 1936 Section 273 | Income Tax Assessment Act 1936 Subsections 273(6) | Income Tax Assessment Act 1936 Subsection 273(7) | Income Tax Assessment Act 1936 Paragraph 273(7)(a) | Income Tax Assessment Act 1936 Paragraph 273(7)(b) Further issues for you to consider | Nil | Anti-avoidance rules | This private-ruling decision is confined to the questions raised.

Reasons for decision: Summary: The income derived by the Fund from its beneficial ownership of the Property is non-arm's length income of the Fund where, in accordance with the Loan Agreement, the interest rate of the Loan is reduced to 0%. The difference between the existing interest rate and 0% interest rate does not increase the capital of the Fund. The amount of interest that is not charged is, therefore, not considered to be a contribution to 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. According to subsection 995-1(1) of the ITAA 1997, 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 for that year less any deductions to the extent that they are attributable to that income. In accordance with subsection 995-1(1) of the ITAA 1997, the phrase 'non-arm's length income' has the meaning given by section 295-550 of the ITAA 1997. There are various subsections in section 295-550 of the ITAA 1997 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) of the ITAA 1997 specifically apply to such amounts derived by an entity as a beneficiary of a trust. Subsection 295-550(4) of the ITAA 1997 states 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) of the ITAA 1997 states that: 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) of the ITAA 1997 are relevant to the present case (and not subsection 295-550(1) of the ITAA 1997, 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 Trustee's entitlement as the beneficiary of the Custody 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 trust income: Taxation Ruling TR 2006/7 (TR 2006/7) explains what amounts are considered to be 'special income' under former section 273 of the Income Tax Assessment Act 1936 (ITAA 1936) which was repealed with effect from 1 July 2007. Former section 273 of the ITAA 1936 has been re-written, with some modifications, in section 295-550 of the ITAA 1997. In accordance with section 357-85 in Schedule 1 to the Taxation Administration Act 1953 (TAA) , to the extent that section 295-550 expresses the same ideas as former section 273, TR 2006/7 is also taken to be a ruling about section 295-550. In accordance with paragraph 102 of TR 2006/7, 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. 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) of the ITAA 1997. In all cases, the determining factor in deciding if a fixed entitlement exists is the terms of the trust instrument under which the trust is constituted. In this case, that is the Custody Deed executed between the Fund Trustee and the Custodian. After considering the terms of the Custody Deed it is clear that the Fund's entitlement to income as the beneficiary of the Custody Trust does not depend upon the exercise of the trustee's, or any other person's discretion, The Commissioner therefore, considers that the Fund derives income as a beneficiary of Custody Trust through holding a fixed entitlement to the income. Therefore, it is subsection 295-550(5), rather than subsection 295-550(4), of the ITAA 1997 that is to be considered further in the present case. If that conclusion were wrong, any income derived by the Fund as beneficiary of the Custody Trust would be non-arm's length income of the Fund pursuant to subsection 295-550(4) of the ITAA 1997. In accordance with subsection 295-550(5) of the ITAA 1997, a trust distribution arising from a fixed entitlement will only be non-arm's length income of a fund if the following three conditions are met: • the entity must have acquired the fixed entitlement under a scheme, or the income must have been derived under a scheme; • the parties to which were not dealing with each other at arm's length; and • the amount of the income is greater than the amount of income that might have been expected if the parties had been dealing with each other at arm's length. | Detailed Reasoning - Scheme: The term 'scheme' is defined in subsection 995-1(1) of the ITAA 1997 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) of the ITAA 1997 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] FCAFC 118; (2011) 195 FCR 416 ( Allen ) 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) of the ITAA 1997. 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 that the series of steps undertaken by the parties that resulted in the acquisition of a fixed interest in the trust estate and the relevant distribution of income from that trust estate were readily seen to be an 'arrangement' to which the various entities were parties, and those results were readily seen to be the consequence of that arrangement. Similarly, for the purposes of applying subsection 295-550(5) of the ITAA 1997 in the present case, the scheme involves the series of steps resulting in the Fund acquiring its fixed entitlement to the income of the Custody Trust and the derivation of the income by the Fund through holding that fixed entitlement. The series of steps that constitute the scheme include: • the purchase of the Property; • the establishment of the Custody Trust; • the establishment and operation of the LRBA; and • the reduction of interest charged on the borrowing to 0% rate of interest. As such it is readily concluded that, for the purposes of paragraph 295-550(5)(a) of the ITAA 1997, the Fund acquired its fixed entitlement to the income of the Custody Trust under a scheme, and the income derived through holding that entitlement is derived under a scheme. | Detailed Reasoning - Parties to scheme 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 (AXA) [2010] FCAFC 134; (2010) 189 FCR 204 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 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': … Further, the Full Federal Court in Allen at 434 held that former paragraph 273(7)(a) of the ITAA 1936 - the immediate predecessor of paragraph 295-550(5)(a) of the ITAA 1997 - 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 the income of the trust and any derivation of 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 LRBA between the Fund Trustee and the Lending Trust (which includes the Loan and establishment and operation of the Custody Trust in favour of the Fund). It is clear that the parties in this case are not in an arm's length relationship. This is because: • Member 1 and Member 2 are the only members of the Fund; • Member 1 and Member 2 are the trustees of the Fund (the Borrower); • Member 1 is the sole director and shareholder of the trustee of the Lending Trust (the Lender); • Member 1 and Member 2 are objects of the Lending Trust; and • Member 1 and Member 2 are the directors and shareholders of the Custody Trust (the Custodian). 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: • other than reducing the interest rate to 0%, there is no intention to otherwise vary the terms of the Loan Agreement; • the Lender is not by way of charging interest, or by any other means, compensated for the opportunity cost in lending the principal to the Fund Trustee, or for the additional risk assumed in relation to recovery of the principal in the event of the borrower's default given the limited recourse nature of the loan and lack of other security; and • the Lender has not sought personal guarantees from the members of the Fund as security for the borrower's performance under the Loan Agreement, The Commissioner considers that the requirements of paragraph 295-550(5)(a) of the ITAA 1997 in relation to the parties not dealing with each other at arm's length are therefore 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) of the ITAA 1997, which is set out in paragraph 295-550(5)(b) of the ITAA 1997, is that the amount of the 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, at 429, observed in relation to former paragraph 273(7)(b) of the ITAA1936 - the immediate predecessor of paragraph 295-550(5)(b) of the ITAA 1997 - that this requires a comparison between a hypothetical arm's length dealing and what actually occurred. 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 income the Fund might be expected to derive through the Custody Trust would be nil. An arm's length party would not be expected to lend capital on the loan terms that form part of the scheme. Without that loan, it might be expected that there would be no continuing investment in the Property through the Custody Trust and no income would be derived by the Fund as beneficiary of the Custody Trust. This conclusion is analogous to the conclusion of the Full Federal Court in Allen at 429, that: [i]t 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 to the Super Fund. The usual expectation of humankind is that one gets what one pays for. Therefore, the Commissioner considers that the final requirement of subsection 295-550(5) of the ITAA 1997 is satisfied. Consequently, any income derived by the Fund as beneficiary of the Custody Trust will be non-arm's length income of the Fund pursuant to subsection 295-550(5) of the ITAA 1997. | Detailed Reasoning - Meaning of 'contribution': The Commissioner has set out his view on the meaning of ' contribution ' as it is used in relation to superannuation funds 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. Whether or not the capital of the Fund will be increased as a result of the Fund not being required to pay interest on the money borrowed under the Loan Agreement will, therefore, need to be determined. Where, as here, an arrangement is put in place to ensure that a superannuation fund does not incur a liability to meet certain expenses, as illustrated by the examples in paragraphs 75, 76, 81 and 82 of TR 2010/1, there is no increase in the capital of the superannuation fund and no contribution is made to the superannuation fund under the arrangement. Also, in Self Managed Superannuation Funds Ruling SMSFR 2009/2 (SMSFR 2009/2), the Commissioner discusses his view of the ordinary meaning of 'borrow' and 'loan'. At paragraph 48 of that ruling the Commissioner recognises that while the obligation to pay interest may evidence the existence of a borrowing or loan of money, it is not a necessary feature of the same. Based on the above, the fact that there is no obligation on the part of the Fund to pay interest on the Loan under the Loan Agreement does not result in an increase in the capital of the Fund. Therefore the amount of interest not charged (that is, the difference between the existing interest rate and 0% interest rate) is not considered to be a contribution received by the Fund. | Detailed Reasoning - Legislative intent - non-arm's length income: 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 the relevant family trust and its beneficiaries who may be required to 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.