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The impact of this case on ATO policy is discussed in Decision Impact Statement: BPFN and Commissioner of Taxation (2021/8256, 2021/8257 and 2021/8258).
BPFN v FC of T
Members:IR Molloy DP
Tribunal:
Administrative Appeals Tribunal, Brisbane
MEDIA NEUTRAL CITATION:
[2023] AATA 2330
ATC 11337
IR Molloy (Deputy President):1. The applicant is the corporate trustee of a self-managed superannuation fund (SMSF).
2. During the years ended 30 June 2015, 2016 and 2017 (the relevant years) the applicant derived income as the beneficiary of a unit trust ("JJUT") of which it was the sole unit-holder.
3. Through a series of Loan Agreements JJUT lent money through two related entities, ABC Pty Ltd (ABC) and X Finance Pty Ltd as trustee for the DEF Trust (DEF), which was ultimately lent to independent third parties who undertook development activities.
4. The structure can be summarised as follows:
- a) JJUT was the lender under the JJUT/ABC Loan Agreement;
- b) ABC was:
- i) the borrower under the JJUT/ABC Loan Agreement; and
- ii) the lender under the ABC/DEF Loan Agreement; and
- c) DEF was:
- i) the borrower under the ABC/DEF Loan Agreement; and
- ii) the lender under a number of third-party loan agreements.
5. The JJUT/ABC and ABC/DEF Loan Agreements are perhaps better described as loan facility agreements. They contemplated that JJUT, ABC and DEF would first agree on each loan by DEF to a third party.
6. They so agreed by a resolution in writing, executed on behalf of each of JJUT, ABC and DEF, described as a Funding Resolution/Memorandum (Funding Resolution). The Funding Resolution typically set out the commercial interest rate payable by the third party, the fees payable to ABC and DEF with respect to the third-party loan, and the security which was required.
7. After the loan and security documentation were executed, and following the Funding Resolution, ABC drew down the required amount from JJUT, which DEF in turn drew down from ABC, and then DEF on-lent the money to the third party.
8. Interest on the loans to the third parties set the rate of interest charged by ABC to DEF, and by JJUT to ABC. It was common ground that the third-party loans were arm's length transactions and the interest was charged at commercial rates.
9. The interest income derived by JJUT through these loan arrangements was distributed to the applicant as JJUT's sole unit-holder and included by the applicant as exempt current pension income (ECPI).
10. Following an audit, the respondent determined that the income was non-arm's length income (NALI) and therefore should not have been included as ECPI.
11. The respondent found that the applicant had made false or misleading statements in respect of these matters and imposed penalties as well as a shortfall interest charge (SIC), issuing notices of amended assessment for the relevant years.
12. On 7 September 2021, the respondent disallowed the applicant's objections to the amended assessments including the penalties.
13. The applicant has applied for a review of the objection decision.
Issues
14. The primary issue is whether the NALI provisions, specifically s 295-550(5) of the Income Tax Assessment Act 1997 ("ITAA97"), apply in respect of the above distributions to the applicant.
15. A secondary issue concerns penalty.
Background
16. The applicant has been the sole unit-holder of JJUT since at least 2006. At all relevant times it had a fixed entitlement to distributions under the JJUT trust deed.
17. The SMSF has four members: Mr J, his wife, and their two children. The members of the SMSF are also the directors of the applicant/corporate trustee.
ATC 11338
| JJUT Interest on loan to ABC | |||
| Loan | 30 June 2015 | 30 June 2016 | 30 June 2017 |
| ABC | $1,204,186.24 | $3,855,184.08 | $2,609,956.73 |
18. JJUT received the following interest under the said loan arrangements in the relevant years.
19. ABC was incorporated on 10 January 1992.
20. At the time of the loan agreements (June 2009) Mr J was the sole director of ABC and the applicant was the sole shareholder.
21. DEF was established as a discretionary trust by deed on 5 August 2002. The corporate trustee was X Finance Pty Ltd, and the primary beneficiaries were Mr J and his wife.
22. Mr J and his son were directors of X Finance Pty Ltd from June 2009 to July 2012. During the relevant period, Mr J was the sole director of the corporate trustee.
23. A Pty Ltd (a company in which Mr J was a director and 80% shareholder) was the sole shareholder of X Finance Pty Ltd.
24. In 2018, Mr J ceased to be a director of X Finance Pty Ltd and the shares were transferred from A Pty Ltd to third parties.
25. Prior to the Loan Agreements, and until 2008, DEF provided building and project development consultancy services.
Loan Agreements between JJUT, ABC and DEF
26. As I have said, JJUT loaned funds to ABC, which on-lent the funds to DEF, and DEF in turn on-lent the funds to third parties.
27. There were features of or concerning the Loan Agreement between the JJUT and ABC[1]
- (a) The loan amount was all loan amounts advanced by the lender or at the borrower's direction or request and as agreed in writing between the lender and the borrower.
- (b) The loan facility was for 15 years or otherwise as agreed or repayable on demand.
- (c) The purpose was for ABC to on-lend the funds to DEF.
- (d) ABC executed a Deed of Charge in favour of JJUT.
- (e) Mr J executed a Guarantee with JJUT.
- (f) The loan must be repaid at the times directed by the lender from time to time.
- (g) In the event of any failed investment or loss on any forward advance or on-advance, the borrower and the lender shall each bear those respective risks and losses from time to time.
- (h) The interest rate shall be no less than the amount or rate at which the monies are invested or forward lent by the borrower.
28. In respect of the Loan Agreement between ABC and DEF:[2]
- (a) The loan amount was all amounts advanced by the lender to the borrower or at the borrower's direction or request and as agreed in writing between the lender and borrower from time to time.
- (b) The loan facility was for 15 years.
- (c) The purpose of the loan facility was for DEF to on-lend the funds.
- (d) By way of an executed Deed of Charge in favour of ABC, DEF provided a fixed and floating charge over all its assets until such time as the loan was repaid.
- (e) Mr J executed a Guarantee with ABC.
- (f) The interest rate payable was to be no less than the amount or rate at which the monies were invested or forward lent by DEF.
- (g) The Trustee for DEF and ABC would equally share any loss incurred by DEF through investing/utilising the borrowed funds.
- (h) There was no maximum loan amount.
29. The Loan Agreements between JJUT and ABC and between ABC and DEF were therefore substantially the same. They contemplated the investing or on-lending of funds sourced from JJUT. They each contemplated that the amounts advanced would be subject to agreement. They contemplated payment of interest at no less than the rate at which monies were invested or on-lent.
30.
ATC 11339
A Deed of Charge between JJUT and ABC, and between ABC and DEF, and two Deeds of Guarantee were executed on 30 June 2009.31. The Deeds of Charge were not registered on the PPSR.
32. In 2017, a new general security interest agreement was executed by ABC and DEF and registered on the PPSR in May 2017.
33. DEF entered into a number of loan agreements with unrelated parties at arm's length.[3]
34. The financing was secured by either first or second mortgages, with the larger loans secured by properties on which the third-party borrowers were conducting development projects.
35. The structure involving JJUT, ABC and DEF, was determined by Mr J on advice from his accountant Mr B. Mr B's firm had been the advisors and accountants for Mr J and his associated entities since 2000.
36. Mr B recommended the structure of the scheme but he did not draft the documents.[4]
37. Mr J explained to my satisfaction his and Mr B's reasons for interposing DEF and ABC between JJUT and the third-party borrowers. Amongst other things, in consultation with his accountant, Mr J determined that it would be preferable that JJUT was not lending direct to the third parties. DEF was to be the 'front-line person' dealing with the third parties for which it would obtain 'proper fees'.[5]
38. Mr J also explained the reason that ABC was interposed. He described it as gatekeeper or someone to keep an eye on DEF.[6]
39. Mr J impressed that he was looking to the long-term when he may no longer be personally involved. He said that his accountants recommended that the loan facilities from JJUT to ABC, and ABC to DEF be long-term arrangements both for longevity and associated benefits such as not having to redo a loan agreement on multiple occasions.
40. As I have said, Mr J gave evidence that he understood, including from advice provided by Mr B, that the dealings between the related entities must be arm's length transactions. So far as he was concerned they took particular care to ensure that was the case.[8]
41. Having seen and heard Mr J and Mr B cross-examined, and on reviewing their statutory declarations[9]
42. As contemplated in the Loan Agreements, for each advance that DEF made to unrelated third parties, JJUT, ABC and DEF executed a Funding Resolution.[10]
43. The Funding Resolutions detailed:
- (a) the loan amount, which was initially drawn down by ABC from JJUT, and subsequently by DEF from ABC;
- (b) the interest rate to be applied on the loan to the third party, and thereby the minimum interest payable under the loans between DEF and ABC, and ABC and JJUT;
- (c) the term of the loan; and
- (d) the security provided by the third party.
44. The Funding Resolutions also set out the fees or other consideration payable to ABC and DEF. By way of example, under a Funding Resolution dated 17 May 2012,[11]
45. Mr J said that on each occasion the fees were negotiated between DEF and the third party based on the market and the circumstances of the loan.[13]
Arm's length dealing
46. The primary issue, whether the NALI provisions apply, turns on s 295-550(5) of the
ATC 11340
ITAA97. That provision, at the relevant time, was as follows:- (5) 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."
47. The scheme, in my view, is the totality of the arrangement between JJUT, ABC, DEF and the third-party borrowers. I do not believe there is any disagreement between the parties on that.
48. As to s 299-550(5)(a) of the ITAA97, in my view the parties were not dealing with each other at arm's length. There is no dispute that DEF was dealing with the third parties at arm's length. But that cannot be said of the dealings between JJUT, ABC and DEF.
49. The directing mind of each of JJUT, ABC and DEF, in relation to these dealings, was Mr J.
50. In
Federal Commissioner of Taxation v AXA Asia Pacific Holdings Ltd,[14]
"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": Trustee for the Estate of the late AW Furse No 5 Will
Trust v Federal Commissioner of Taxation (1991) 21 ATR 1123 at 1132 per Hill J. The reference in Furse 21 ATR 1123 to "real bargaining" is significant.It focuses on actual dealing between the parties: see also Re Hains (deceased);
Barnsdall v Federal Commissioner of Taxation (1988) 81 ALR 173. That is not surprising. It is the same mental process as that described by Griffith CJ in
Spencer v The Commonwealth (1907) 5 CLR 418 at 432.The question of whether parties dealt with each other at arm's length in respect of a particular dealing is one of fact in each case:
Granby v Federal Commissioner of Taxation (1995) 129 ALR 503 at 507. What is required is that "parties to a transaction have acted severally and independently in forming their bargain": Granby 129 ALR 503 at 507. Put another way, it requires consideration of how "unrelated parties, each acting in his or her own best interest, would carry out a particular transaction":
Australian Trade Commission v WA Meat Exports Pty Ltd (1987) 75 ALR 287 at 291."
51. In Minister of National
Revenue v Merritt,[16]
"In my view, the basic premise on which this analysis is based is that, where the 'mind' by which the bargaining is directed on behalf of one party to a contract is the same 'mind' that directs the bargaining on behalf of the other party, it cannot be said that the parties are dealing at arm's length. In other words where the evidence reveals that the same person was 'dictating' the 'terms of the bargain' on behalf of both parties, it cannot be said that the parties were dealing at arm's length."
52. Nothing that could be described as 'real bargaining' occurred in respect of the respective dealings between JJUT, ABC and DEF. What was agreed was based on Mr J's views about the market, and what was considered by him to be fair and reasonable based on the work that was done by each entity and the market rate for that work.[18]
53. It has been pointed out that in a particular fact situation related parties may deal with each other at arm's length in relation to a transaction.[19]
54. The applicant submitted that the arrangement between the parties was what
ATC 11341
could be expected from dealings between parties acting at arm's length. That may be so, but I do not consider it assists here, where there is direct evidence of what occurred in terms of paragraph (a) of s 296-550(5).55. The enquiry is whether in fact the parties I have been referring to, in their respective dealings with one another, were or were not dealing with each other at arm's length. Plainly they were not.
Income derived if parties dealing at arm's length
56. The issue then is whether, under paragraph (b) of s 295-550(5) of the ITAA97, the amount of 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.
57. The applicant submitted, firstly, that s 295-550(5)(b) requires a comparison between the actual transaction (and the income derived) and that which might have been expected to have been the position if the scheme had not been entered into.
58. The applicant submitted that the ultimate transactions involved the lending of funds, sourced from JJUT, to the third-party borrowers. The applicant submitted that the proper comparison is a hypothetical transaction in which JJUT dealt directly with the third parties on the same terms as DEF lent to those borrowers.
59. Pursuant to that hypothetical situation, it was submitted JJUT would have derived interest income paid by the third parties, admittedly at commercial rates pursuant to arm's length transactions, equating to (or perhaps greater than) the interest income JJUT actually received.
60. Under these hypothetical transactions the intermediate entities, ABC and DEF, do not feature at all. The applicant relied on the observation of Allsop CJ in
Chevron Australia Holdings Pty Ltd v Commissioner of Taxation[20]
61. I do not accept that the hypothetical transactions should be modified to the extent of ignoring ABC and DEF. I do not consider that would be a modification, 'to a degree', as contemplated in Chevron, but would instead be a substantial restructuring of the scheme. Nor do I think it is a necessary modification so as to permit the transactions to be analysed.
62. To accept the applicant's submission would fail to give effect to the wording and intent of s 295-550(5)(b). The reference in that provision is to the amount of income the entity might have been expected to derive if those parties had been dealing with each other at arm's length. In this case 'those parties' include ABC and DEF.
63. The applicant submitted, in the alternative, that the comparison is with what income might have been derived if there had not been a lack of independence between the parties in dealing with each other in the actual scheme. That was also the respondent's submission. I think that essentially is correct.
64. The task, as I see it, involves considering what the parties to the scheme would have agreed, particularly JJUT, ABC and DEF, and what income would have ultimately been derived, if the parties to the scheme had been dealing with each other at arm's length.[21]
65. The respondent submitted that the evidence does not support a finding that the scheme would have been entered into on the same terms as agreed between JJUT, ABC and DEF if those parties were dealing at arm's length. The respondent pointed out that no margin was charged on interest rates between the various lenders. He also submitted that ABC's fees were 'unsustainably low'.
66. The respondent submitted that by keeping all of the interest for itself, and paying ABC what were described as unsustainably low fees, the applicant thereby ensured that it earned more than it would have if the parties were dealing at arm's length.
67. The respondent called evidence from one witness, Richard Mark Wist, in support of its contentions and, of course, relied upon other evidence before the Tribunal. Mr Wist provided two reports[22]
68. The applicant contended that the interest income the applicant derived in each of the relevant years was not more than the amount it
ATC 11342
might have expected to derive if the parties to the scheme had been dealing with each other at arm's length. The applicant called evidence from Mr J and Mr D, whose evidence I have referred to, and also from Mr C, Alan Kenneth Gale and Liam Ross McLindin. All of these witnesses provided written statements or reports and were also cross-examined.69. Mr C is a solicitor. He gave evidence of what, in his experience, is industry practice.[23]
70. Their evidence, independently of one another, was that the fees (including profit share and absence of interest margins) charged by DEF and ABC were commercial and consistent with what would have been earned by those parties if they had been dealing with each other at arm's length.[25]
71. The respondent contended that Mr C did not draw upon proper comparators because he gave evidence of fees recovered by brokers and managers, and likewise Mr Gale gave evidence of broker's fees. The respondent pointed out that ABC and DEF were not mortgage managers or brokers, they were lenders.
72. It is true that the Loan Agreements and the loans to third parties were the foundation of the scheme. But the terms of the Loan Agreements, and in particular the detail provided by the Funding Resolutions, including the requirement that each of JJUT, ABC and DEF agree to a third-party loan, the way in which the risk was shared, and the parties' respective roles in the transactions, render Mr C's and Mr Gale's comparators relevant and appropriate. The respondent identified other points of distinction such as the longevity of the subject loan facilities. I have taken such matters into account in my conclusions in respect of their evidence.
73. The respondent was critical of Mr C and Mr Gale on the basis that neither was an independent witness. As to Mr C it was pointed out that he is a partner in a law firm that has acted for Mr J and his related entities for at least 15 years. His firm drafted the documents to implement the scheme. I have taken that into account. I could not detect anything in Mr C's evidence, written or oral, which causes me to question the correctness of his evidence or his integrity. There was no indication, including in his demeanour whilst under cross-examination, to cause me to reject or discount his evidence.
74. The respondent pointed out that Mr Gale has 'a personal and professional relationship' with Mr J going back 20 years. Mr Gale, however, did not accept that their relationship was personal. He described his relationship with Mr J 'as a professional relationship'.[26]
75. The applicant's case finds considerable further support in the report and evidence of Mr McLindin.[27]
76. Mr McLindin referred to the agreement concerning risk - that is the provision that limits the amount of principal that JJUT can recover from ABC, and ABC from DEF, to the amount actually received from the third party:
"In the event of any failed investment or loss on any forward advance or on-advance the Borrower and Lender shall each bear those respective risks and losses from time to time."
77. Mr McLindin said of this provision:
"Again, this is, in my experience, a fairly typical mechanism for an on-lending arrangement of this nature. Rather than being suggestive of the parties not dealing at arm's length, it is designed to limit each parties' loss to what they could have gained, so that a particular party in an on-lending chain is not unfairly disadvantaged or left 'holding the can' in the event of a failed investment down the line."
78.
ATC 11343
Mr McLindin rejected the suggestion that this was not a common practice within the private lending market.[29]79. The respondent claimed that Mr McLindin was not in truth an independent witness. It is true that prior to accepting 'an engagement' to provide an expert report in the proceeding, Mr McLindin was approached by Mr J and they conferred on a solicitor-client basis. However, in the course of taking instructions and preparing his report, Mr McLindin's communications were mainly with the applicant's Brisbane solicitors having the carriage of this proceeding on its behalf.
80. The submission is that it is inconceivable that Mr McLindin would not be influenced (whether consciously or subconsciously) to give evidence 'in favour of his client'. I think this analysis is unfair to Mr McLindin. To place his role in context it should be pointed out that the respondent's first report from Mr Wist dated 10 March 2023 was served a relatively short time before the hearing. It was in those circumstances that Mr McLindin was approached by Mr J as possibly an appropriate person to consider the documentation and Mr Wist's report and also provide an expert report. Mr McLindin considered the documentation and Mr Wist's report and provided his report within a relatively short time.[30]
81. The fact that Mr McLindin had an initial conference with Mr J to be appraised of the proceeding is unsurprising in the circumstances. Time was short and they were in the same locale. Thereafter Mr McLindin appears to have dealt with the applicant's solicitors on the record based in Brisbane. Mr McLindin impressed me as having the requisite expertise and experience to undertake the task. The fact that he had an initial meeting with Mr J, or even that he gave what must have been preliminary advice, is unremarkable in the circumstances.
82. I did not detect anything in the content of Mr McLindin's evidence, or in the manner in which he answered questions under cross-examination, to indicate that he had adopted anything like the role of advocate for the applicant whether consciously or subconsciously. He impressed me as thoughtful, professional and objective. I am satisfied that he was not influenced, as the respondent contends, to give evidence in favour of the applicant.
83. Mark Richard Wist has been a registered valuer. He has extensive experience in finance. He does not have the significant exposure to private lending transactions comparable to Mr Gale, Mr C and McLindin.[31]
84. Mr Wist said there was little functional relevance in ABC standing between JJUT and DEF, but in cross-examination accepted it could have some role, and said that although it was not what he would do or is done in his experience, that does not mean it is wrong.[36]
85. Mr Wist said in a reasonably typical lending arrangement income is earned by intermediate parties via a margin added to the lender's own costs of the funds. He said:[37]
… a reasonably typical lending scenario might be that the source of funds agrees to capitalise or provide capital to its lender and then that lender would typically, on-lend at a higher rate and the difference between those two rates would be a margin and it's the way banks typically operate, for example in that they source their capital from depositors or other institutional lenders at rates that are lower than those at which they on-lend to their customers and that is the genesis of their profit I guess, that margin.
86. The respondent submitted that under Mr Wist's reasonably typical lending scenario, the source of funds agrees to capitalise or provide capital to its lender and then that lender typically on-lends at a higher rate and the difference between those two rates would be a margin. The respondent's submission is that JJUT derived more interest income under the scheme than it would have received if it had loaned funds to ABC under 'a reasonably typical lending scenario'
ATC 11344
whereby there were interest rate margins between each lender in the chain.87. Mr Wist also said he has not seen a situation 'where that lender offers to share in the risk that the borrower, through its own activities, loses capital in some way'.[38]
88. Mr Wist has substantial knowledge and experience in the field of lending, but mainly involving banks and other large lenders, not so much in private lending.[40]
89. As to the respondent's submission on sustainability, Mr Wist said[41]
I analysed the fees charged by ABC in my report at 3(i). This analysis, if representative of all lending activity engaged in by ABC and on the basis that ABC did not retain an interest rate margin, averages at approximately $10,600 per annum in the relevant period between May 2012 and September 2016. This would not, in my opinion, represent a viable minimum proposition for the operation of a conventional arm's length commercial lending entity.
90. Mr Wist opined that ABC would not be able 'to properly operate a profitable lending business with conventional cost structures'.[42]
91. It is not clear what Mr Wist meant by a 'lending business with conventional cost structures'. There is no reason to assume, in the hypothetical arm's length arrangement, that this intermediate entity could not be 'operated' from home by one person with the help of a part-time book-keeper just the same as ABC.
92. I do not accept the respondent's sustainability argument. The applicant successfully took issue with Mr Wist's assessment of ABC's average earnings. And apart from not knowing what Mr Wist precisely had in mind when he referred to 'a lending business' and 'conventional cost structures', there are insufficient facts to support his and the respondent's proposition.
93. Moreover, the argument does not directly address the issue. It does not satisfy me that I should not accept the evidence of Mr C, Mr Gale and Mr McLindin, that the fees ABC charged were consistent with market rate fees charged by parties dealing at arm's length.
94. I am satisfied the scheme established under the private lending facility did not differ from that which might be expected to have operated between independent parties dealing independently with one another in the private lending market at the time
95. I am satisfied based on the evidence of Mr C, Mr Gale and Mr McLindin that JJUT did not derive income that was 'more than the amount that the entity might have been expected to derive … when dealing at arm's length'. I am satisfied that the relevant interest income received by the applicant in the 2015, 2016 and 2017 income years was not NALI.
Conclusion
96. The objection decision should be set aside. The applicant's objections to the amended tax assessments for the 2015, 2016 and 2017 income years should be allowed.
97. The objection to the penalty assessments for each of those income years should also be allowed. There is no occasion for the shortfall interest charges which should therefore also be set aside.
Footnotes
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