Private ruling: Non-arm's length income
Date of advice: 24 March 2016
Published: May 2016
Ruling period: Income year ended 30 June 2016 | Income year ended 30 June 2017
Date scheme commenced: 1 July 2015

Ruling: Q1: Will the rental income received by the self-managed superannuation fund (the Fund) from the rental of a Property to a third party be non-arm's length income for the purposes of section 295-550 of the Income Tax Assessment Act 1997 (ITAA 1997)? | A1: No

Relevant facts and circumstances: The Applicant is a complying self-managed superannuation fund. The Applicant has a corporate trustee (the Trustee). The Members are the directors and shareholders of the Trustee and are the only members of the Applicant. The Property is currently owned by a Company as trustee for a (the Trust). The Members are the directors, shareholders of Trust and beneficiaries of the Trust. The Trust currently leases the Property to an unrelated third party, the Practice that runs a practice from the Property. The practice was originally carried on by the members and their service entities until it was sold in a year prior to the sale of the Property. Prior to the sale of the practice, the Trust leased the Property to a practice owned by the Members under a lease: The lease provided the following: (a) The terms of when the lease would end (b) The tenant had the option to extend (c) The amount of rent per annum subject to yearly reviews (d) The tenant's responsibilities. The terms of the current lease were negotiated by the Practice as part of the sale of the practice while the Trust owned the property. The Practice requested the Trust enter into a new lease on the following terms: I. The initial term of was to commence on the day the practice was acquired II. The Practice has options to extend the lease III. The initial rent was specified per annum, subject to periodic reviews IV. The Practice is responsible for all outgoings One of the conditions of the sale of the Practice was that the Members are required to work for the Practice for a minimum period. The Property was valued just before settlement. For the purposes of that valuation, the valuer adopted a market value rent. The Applicant is proposing to acquire the Property from the Trust at market value The Applicant will pay cash consideration for the transfer of the property. The consideration for the acquisition of the property will be the market value determined by an independent value. The market value consideration will be paid in full by the Applicant.

Relevant legislative provisions: 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) | Income Tax Assessment Act 1997 Subparagraph 295-550 (1)(a) | Income Tax Assessment Act 1997 Subparagraph 295-550 (1)(b) | Income Tax Assessment Act 1997 Subsection 995-1(1).

Reasons for decision: Summary: Ordinary income or statutory income derived by the Applicant from the rental of the Property will not be non-arm's length income in accordance with subsection 295-550(1) of the ITAA 1997 if: • The leasing of the Property and the acquisition of the Property by the Applicant from the Trust is as set out in the facts. | Detailed Reasoning - Non-arm's length income: Section 295-545 of the ITAA 1997 provides that the taxable income of a complying superannuation fund is split into a non-arm's length component and a low tax rate component. The note to subsection 295-545(1) explains that a concessional rate of tax applies to the low tax component of a complying superannuation fund's taxable income, while the non-arm's length component is taxed at the highest marginal rate. These rates are set out in the Income Tax Rates Act 1986 and are 15% and 47% respectively for the 2014-15 income year (see sections 26 and 35 of that Act). 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. According to 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(1) 1997 specifically applies to such amounts derived by an entity as per sub paragraph 295-550 (1) (a) from a scheme the parties to which were not dealing with each other at *arm's length in relation to the scheme; and sub paragraph 295-550 (1) (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 - Scheme: Under subsection 295-550 (1) of the ITAA 1997 there must be a scheme under which the Fund derived amount or amounts of ordinary or statutory income. 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) 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) 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, 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(1) of the ITAA 1997, the scheme referred to in that subsection may be identified as including the circumstances under which the Applicant: (i) Acquired the Property from the related party (ii) Derived amounts of ordinary or statutory income though the holding of the Property. Similarly for the purposes of applying subsection 295-55 (1) of the ITAA 1997 in the present case, the scheme referred to in that subsection may be identified as involving the series of steps undertaken to give effect to the leasing and sale of the Property . The scheme includes the leasing of the Property to the unrelated third party and the acquisition of the Property by the Applicant from a related party of the Applicant. These steps will result in the Applicant acquiring its entitlement to receive ordinary and statutory income as the owner of the Property As such, it is readily concluded that ,for the purposes of paragraph 295-550(1)(a) of the ITAA 1997, the ordinary and statutory income of the Applicant derived by the Applicant as the owner of the Property is so 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 dealing with each other at arm's length. The definition of 'arm's length' in 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 (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) 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 entitlement to income, in this case the Property ,and any derivation of ordinary or statutory income by the entity through holding that entitlement which would be the rental income from the leasing of the Property. In this case this means that regard may be had to, amongst other things, the acquisition of the Property by the Applicant and the lease of the Property to the unrelated third party. It is clear that there are dealings between parties that are not at arm's length. This is because: • The Fund has a corporate trustee - the Trustee • The Members are the directors and shareholders of the Trustee and are the only members of the Fund • The Property is currently owned by a related Company as trustee for the Trust • The Members are the directors, shareholders and beneficiaries of the Trust Assessing the circumstances holistically however, the Commissioner considers that whilst the parties are not arm's length they are dealing with each other as arm's length parties would do. Aspects which, taken together, the Commissioner considers leads to that conclusion include: • The Trust currently leases the Property to an unrelated third party which runs a practice from the Property. • The lease was initially between related parties as the Trust leased the Property to a practice under a lease which existed years before the sale of the practice. It is accepted that the dealings were at arm's length with respect to the initial lease as: 1. The terms of the lease were specified in the lease agreement 2. Rental income was being paid The tenant had the option to extend the period 3. The initial rent was subject to periodic reviews 4. The tenant was responsible for all outgoings • The terms of the current lease are accepted as dealings that are at arm's length as the lease provided as follows: i. The initial term will commence on the day the dental practice was acquired ii. The Practice has options to extend the lease iii. The initial rent per annum is subject to periodic reviews iv. The Practice is responsible for all outgoings With respect to the acquisition of the Property at market value, the Applicant is proposing to acquire the Property from a related party of the Applicant at market value. The Applicant will pay cash consideration for the transfer of the property. The consideration for the acquisition of the property will be the market value determined by an independent valuer. The market value consideration will be paid in full by the Applicant. Based on the above, the Commissioner considers that sub paragraph 295-550(1) (a) of the ITAA 1997 does not apply as the scheme from which the Applicant will derive rental income from the Property is considered to be arm's length | 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. The purchase consideration to be paid for the acquisition of the Property will be the market value determined by an independent valuer. The market value consideration will be paid in full by the Applicant. The Commissioner considers that paragraph 295-550(b) of ITAA 1997 is also satisfied. In conclusion, if the acquisition of the Property by the Applicant is financed in the way described in this ruling and the terms of the lease of the property are also as set out in this ruling, then any ordinary or statutory income derived by the Applicant from the Property will not be considered to be non-arm's length income pursuant to section 295-550 of the ITAA 1997.