Under the new tax system for MITs, the arm's length income rule was introduced in the context of the repeal of Division 6B of the Income Tax Assessment Act 1936 (ITAA 1936: which taxed certain public unit trusts as corporate entities). This new rule removes the incentive to shift profits from an active business of a related party to a MIT by engaging in non-arm’s length activity.
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If we determine that a MIT has derived non-arm’s length income, the trustee may be liable to pay income tax on that income at the standard corporate tax rate of 30%.
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Non-arm’s length income
Ordinary or statutory income is non-arm’s length income of a MIT if:
- it is derived from a non-arm’s length scheme
- the amount is more than the MIT might have been expected to receive if the parties had dealt with each other at arm’s length.
An amount of non-arm's length income is the whole amount, not just the component in excess of the amount that would have been derived if the parties were dealing at arm's length. However, the trustee will only be liable to tax on the amount by which the non-arm's length income exceeds the amount that would have been expected if the parties had dealt with each other at arm’s length.
Certain amounts are specifically excluded from being non-arm’s length income:
- a distribution to a MIT from a corporate tax entity
- a distribution to a MIT from a trust that is not a party to the non-arm’s length scheme
- a return to a MIT an entity pays or provides on a debt interest if the rate of the return does not exceed the benchmark rate of return or a rate of return equal to the shortfall interest charge
- some distributions from another trust that is a party to a non-arm’s length scheme, where the income distributed is not non-arm’s length income.
Non-arm's length scheme
A non-arm's length scheme is where parties are not dealing with each other at arm’s length and at least one of the parties to the non-arm’s length scheme is not a MIT for the income year.
This includes arrangements lacking the normal commercial distance between unrelated parties, where the financial outcomes of the arrangement are different to what they would be if the parties were not related or connected in some way.
Commissioner's determination
The arm’s length income rule is an integrity rule that only applies if the Commissioner makes a determination:
- specifying an amount of non-arm’s length income, for a MIT for a specified income year
- where the amount of non-arm’s length income is reflected in either the trust components of an AMIT or the net income of a MIT.
The determination does not form part of an assessment but may be included with a notice of assessment. If you receive a determination you disagree with, you may lodge an objection.
Consequences of a determination
Once the determination is made, the amount of income exceeding an arm’s length amount (less any deductions relating only to that excess amount) will be taxed at the standard corporate tax rate of 30%.
To prevent double taxation for an AMIT the amount of non-arm’s length income is taxed at the corporate rate and taken to be an 'over' in the year of the determination.
For a MIT that is not an AMIT (Non-AMIT) the net income is reduced by the amount subject to trustee taxation at the corporate rate – for the income year to which the determination relates.
For example, the Commissioner of Taxation makes a determination on 31 August 2021 about a Non-AMIT's 2019 income year. The Non-AMIT is required to reduce its net income for the 2019 year by the amount of non-arm’s length income the trustee was taxed on at the corporate rate.
Note: The determination does not necessarily mean the trust is a trading trust within the meaning of Division 6C.
Trustee can be subject to an administrative penalty
An administrative penalty is imposed on taxpayers entering into schemes to reduce their tax liabilities, including schemes to derive non-arm’s length income.
The trustee of a MIT or AMIT is liable to an administrative penalty if we amend an assessment issued to the trustee for the income year and, as a result, the trustee is liable to pay an additional amount of income tax.
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