Recent ATO rulings have seen income from assets acquired under a related-party loan treated as non-arm’s length. Graeme Colley discusses the future implications for SMSFs.
From a superannuation technical point of view, 2014 was a relatively quiet year.
However, if there’s one thing that stirred the pot it was the SMSF sector’s reaction to the private binding rulings issued by the tax commissioner on limited recourse borrowing arrangements (LRBA) involving non-commercial loans.
The main issue was not whether the LRBA was done correctly, but the impact of the interest-free loan made to the SMSF on the income received by the fund from the custodian, holding or bare trust (holding trust).
In at least one case the commissioner intends to tax, or has taxed, the income earned by the fund from the LRBA as non-arm’s-length income under section 295-550 of the Income Tax Assessment Act 1997 (ITAA 1997) at 45 per cent (47 per cent from 1 July 2014).
The history of taxing non-arm’s-length or special income received by a superannuation fund is not new and goes back to the 1960s when it was taxed at penalty rates determined basically by the company tax rate prevailing at the time.
The reason for the imposition of the penalty had to do with avoidance practices that developed with undistributed profits tax of private companies and the payment of dividends to superannuation funds that were tax free until the late 1980s.
This led to very specific provisions in the superannuation rules to assess dividends from private companies and a less prescriptive regime for other income received by the fund from other non-arm’s-length transactions.
When the Income Tax Assessment Act 1936 (ITAA 1936) was amended to include Part IX in 1989, section 273 included a provision relating to ‘special income’ derived by the superannuation fund that was taxed at penalty rates.
These new provisions were an extension of the earlier law and included a provision on what was considered a scheme or arrangement in relation to amounts received by the fund from fixed entitlements in a trust.
Undistributed profits tax was abolished by the taxation reforms in 1987 removing the underlying purpose for the legislation, however, this probably resulted in a greater need for the penalty provisions.
The transfer of the superannuation provisions of the ITAA 1936 to the ITAA 1997 in 2007 included section 295-550, which reflected the previous provisions of section 273 and treated the commissioner’s Taxation Ruling 2006/7 on special income to apply to the new provisions “to the extent that it expresses the same ideas as the repealed provision”.
A significant change included in the new legislation is that under section 295-550 the assessment of non-arm’s-length income is left up to the taxpayer to determine in contrast to section 273, which left the determination of ‘special income’ to the commissioner.
In theory a taxpayer was required under section 273 to seek the commissioner’s discretion that the income did not qualify as non-arm’s-length income.
It would be interesting to know whether there was any difference in what was declared as non-arm’s-length income pre and post the change. In view of the relatively poor understanding of the operation of the legislation, it could be assumed many cases escaped the penalty net solely out of ignorance or misunderstanding of the provision.
Appeals pursued by the commissioner in the courts and tribunals during the 50 or so years since the non-arm’s-length income legislation came into play seem to have been limited to relatively few cases, with the revenue being the victor in the majority of cases.
There were a number of cases in the 1980s and 1990s involving the interpretation of the legislation originally included in the ITAA 1936 in the 1960s, but virtually no appeals on the provisions of section 273 until about 2009 with the decision in FFWX v Commissioner of Taxation.
That’s a long time between drinks in anyone’s language.
Subsequent to the decision in FFWX, there were a number of cases on special income, such as Allen’s Asphalt Superannuation Fund v Federal Commissioner of Taxation (FCT) in 2010, Darralen Pty Ltd as Trustee of Henfam Superannuation Fund v FCT in 2010, SCCASP Holdings Pty Ltd as Trustee for the H&R Super Fund v FCT in 2013 and The Trustee for MH Ghali Superannuation Fund v FCT in 2012.
The high point in the litigation to date seems to be the Allen’s case, which nearly made it to the High Court.
Although most of the cases related to whether the fund income should be taxed at the standard or special penalty rate of tax, the Ghali case considered whether the income received should have been tax free as income arising from the fund’s pension assets rather than taxed as special income at the penalty rate of tax.
In that case, it was the nature of the trust that led to the income being treated as non-arm’s-length income.
Last year provided another stage in the commissioner applying section 295-550 in situations where taxpayers had entered into LRBAs with ‘non-commercial’ loans.
In one of the ATO’s private binding rulings (Private Binding Ruling 1012414213139) that received wide publicity the superannuation fund had been provided with interest-free loans and had used the amounts borrowed to buy a number of single acquirable assets under separate LRBAs, such as shares in publicly listed companies and real estate.
The commissioner treated the income distributed by the trust in relation to each asset as non-arm’s-length income on the basis the amount received was greater than if the arrangement had involved a loan determined on a commercial arm’s-length basis.
It should be remembered the ATO’s private binding ruling decisions are restricted solely to the facts as submitted in the ruling request.
Unfortunately, the SMSF industry seems to have adopted the adverse decision as applying universally to all transactions involving non-arm’s-length parties.
It should also be remembered that before that private binding ruling there were a number of other cases in which the commissioner considered the relevant income was at arm’s length.
The other cases also answered a range of questions concerning the operation of Part IVA as well as whether an interest-free loan made to the superannuation fund for purposes of the LRBA was considered a contribution to the fund.
Subsequent to the commissioner’s adverse ruling there have been a number of rulings where income received from related parties has been treated as being at arm’s length.
It must be remembered that income derived by the fund can be non-arm’s-length income where the parties are not related in the superannuation sense but a scheme or arrangement has been put in place to achieve a particular result.
In late May, meetings were held with ATO staff concerning the adverse ruling and other rulings that had treated income received from LRBAs on an arm’s-length basis.
The result was the publication of two ATO interpretive decisions (ID), ATO ID 2014/39 and 2014/40, and a facts sheet on non-commercial LRBAs.
In the ATO IDs, the commissioner’s arguments are discussed based on the facts provided and a number of arguments are put forward as to why the income received by the superannuation fund was to be treated as non-arm’s-length income.
One argument is the income derived by the superannuation fund is as a beneficiary of a trust. The requirement to have the single acquirable asset held on trust is a mandatory requirement under the LRBA rules in section 67A of the Superannuation Industry (Supervision) (SIS) Act 1994.
The commissioner considers the amount received by the fund greater than what would have been received had the fund not obtained an interest-free loan to allow the holding trust to make the purchase. Therefore it is treated as non-arm’s-length income within the ambit of section 295-550 of the ITAA 1997.
A number of commentators have indicated there may be a number of questions arising here as the legislation refers to the fact it is the ordinary or statutory that is to be considered as not being at arm’s length to come within the penalty provisions.
However, a number of comments by the courts and tribunal have indicated section 295-550 has a wide scope, and on this basis would appear to include other transactions outside the ordinary or statutory income received by the fund as forming part of the scheme or arrangement with the aim of achieving a particular result.
Whether the scheme’s provisions extend as far as the nature of the loan raised or other features of the superannuation fund borrowing would depend on the breadth of the term in relation to the fund deriving the relevant income.
Another argument put forward by the commissioner is that if the income received from the holding trust is not from a fixed entitlement to income due to the nature of the holding trust, then the income would be treated as non-arm’s-length income in any case.
This distinction is extremely important and, as shown by the decision in the Ghali case, will result in the income automatically being taxed at the penalty rate.
This must be considered a relatively radical view as it could mean a substantial number of LRBAs would be taxed at the penalty rate irrespective of whether a scheme or arrangement was in place to manufacture a desired outcome.
The commissioner’s facts sheet concerning non-commercial loans, which was requested by industry representatives, reiterates that not all related-party LRBAs give rise to non-arm’s-length income.
It is the overall terms of the relevant loan and whether they are consistent with what an arm’s-length lender would accept that determine whether the arrangement is at arm’s length.
Things taken into account include the nature of the single acquirable asset, the amount borrowed and the terms of the loan, including the loan-to-value ratio, interest rate, repayment terms and the security offered.
The commissioner also recommends that documentation be retained by the fund to establish the details of the loan.
This seems common sense and you would think a mandatory requirement under the SIS Act when maintaining appropriate books and records in relation to the operation of the fund.
While the Financial System Inquiry recommended the abolition of LRBAs, we still have a long way to go to see whether any change will be implemented.
Whatever the outcome, the legislation relating to non-arm’s-length income will not disappear as the provisions of section 295-550 will continue to operate not only in relation to aspects of LRBAs, but also those transactions where the parties, related or unrelated, have acted in a way to obtain a particular result.
One thing for sure is that non-arm’s-length income remains the big uncertainty for related-party loans in which an SMSF is involved.
However, in view of this uncertainty and the breadth of what is meant by scheme or arrangement, trustees should consider obtaining a private binding ruling before entering into arrangements where there are doubts about the transaction being not at arm’s length.
Whatever the outcome of individual cases, we can expect a raft of appeals to the courts and tribunals.