CASE 5/94
Members:BH Burns DP
BC Lock M
DJ Trowse M
Tribunal:
Administrative Appeals Tribunal
BH Burns (Deputy President), BC Lock and DJ Trowse (Members)
There are two applicants in these references. One is a proprietary company which conducts a water treatment consultancy business; the other is a related superannuation fund. The matters in issue are the deductibility of contributions made by the company (``the Company'') to the superannuation fund (``the Superannuation Fund'') for the benefit of its two director shareholders, and whether the income derived by the Superannuation Fund is exempt from income tax. The decision on the objections relates to the 1986 and 1987 years of income. Additional tax imposed on the Superannuation Fund for an incorrect 1986 return is also in issue.
2. The Tribunal had before it the various T documents supplied in terms of s. 37 of the Administrative Appeals Tribunal Act 1975, together with four exhibits tendered on behalf of the applicants (Exhibits A1-A4) and six on behalf of the respondent (Exhibits R1-R6). The Tribunal also heard evidence which is accepted from (B) a director of the Company who was also a trustee of the Superannuation Fund and a director of the company acting as trustee of a Unit Trust. The applicants were represented by
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Mr BA Beaumont and the respondent by one of his officers.3. Subject to various conditions, the income of certain superannuation funds established for the benefit of employees is exempt from income tax - see former provisions of section 23F of the Income Tax Assessment Act 1936 (``the Act'') for the 1986 year and section 23FC for the 1987 year. However, sub-sections 23F(18) and 23FC(4) make it clear that the exemption does not extend to income derived by a superannuation fund from a ``transaction'' if the parties to the transaction were not dealing with each other at arm's length and that income is greater than the income that might have been expected to have been derived if those parties had been dealing with each other at arm's length. In that event the income flowing from such a source becomes taxable at the rates prescribed by section 121CA for 1986 and by section 121D for 1987. Transaction is defined in sub-sections 23F(1) and 23FC(5) to include a series of transactions.
4. A further limitation to exemption is contained in former section 121C of the Act and which has relevance to the 1986 year. The part that has possible application in this matter is embodied in sub-section (5) which provides:
``The investment income of a superannuation fund derived during the year of income, being a superannuation fund that was established before 12 March 1985, is not exempt from income tax by virtue of section 23F or 23FB unless, at all times during the year of income, the cost of the in- house assets of the fund did not exceed-
- (a) in the case of the year of income commencing on 1 July 1994 or a preceding year of income-
- (i) the cost of the in-house assets of the fund as at 11 March 1985; or
- (ii) 10% of the cost of all the assets of the fund,
- whichever is the greater; and
- (b)...''
The terms in-house asset, associate and investment are defined in the following manner:
```in-house asset', in relation to a superannuation fund, means an asset of the fund that consists of a loan to, or an investment in, an employer sponsor of the fund or an associate of an employer sponsor of the fund,...;
`associate' has the same meaning in relation to a person as that expression has in relation to a person in section 26AAB;
`investment' means any mode of application of money for the purpose of gaining interest, income or profit;''
Failure of the in-house asset test results in the investment income of the fund being taxed in accordance with the provisions of section 121CC.
5. For the year ended 30 June 1987 and subsequent years, the Insurance and Superannuation Commission (``the Commission'') assumed the responsibility of reviewing and monitoring the affairs of superannuation funds. The task of the Commission is to be satisfied that the conditions laid down in terms of the Occupational Superannuation Standards Act 1987 have been met and, if so, to issue a compliance notice. As part of that process, the Commission is possessed of a discretion whereby, in special circumstances, it is empowered to treat the fund as if the conditions had been satisfied notwithstanding a breach of the investment standard. Under former section 23FC, which is the one applicable to the 1987 year, the income of a fund in receipt of a notice from the Commission is, subject to two exclusions, exempt from income tax. The only relevant one of those is where excess income is derived from a non-arm's length transaction.
6. The deductibility of contributions made to superannuation funds for the benefit of employees is governed by the provisions comprised in Subdivision AA of the Act. Sub- section 82AAC(3) provides that a deduction is not allowed in respect of amounts paid to a fund in ayear of income if section 121CC applies to the fund in relation to that year of income. It will therefore be seen that a failure of the in- house asset test contained in section 121C carries as a consequence the denial of any deduction for contributions made to such a fund.
7. The respondent disallowed in full the objections lodged on behalf of the Superannuation Fund for the following reasons-
- 1986 Year
- • that the income flow from a non-arm's length transaction was excessive and thus
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attracted the punitive rate of 50c in the dollar as prescribed by section 121CA; - • that the in-house asset requirement had been breached and thus the investment income of the fund was to be taxed in accordance with section 121CC which imposed a rate of 30c in the dollar;
- • that in all of the circumstances, the additional tax of 20% of the tax avoided be maintained.
- 1987 Year
- • that the income flow from a non-arm's length transaction was excessive and thus attracted the punitive rate of 50c in the dollar as prescribed by section 121D;
- • that no compliance notice had issued from the Commission, nor, having regard to the breaching of the in-house requirement, was one likely to issue, and thus section 121CC had application.
8. The reason for the denial of the deduction to the Company of contributions made to the Superannuation Fund is elementary. In terms of sub-section 82AAC(3), no deduction is permitted if, as in this matter, section 121CC applies to the Fund.
9. Portion of the respondent's decision relating to the 1987 year, more specifically that part appertaining to the in-house rule, required reconsideration when on 11 May 1993, the Commission decided to treat the Superannuation Fund as if it had satisfied the conditions under the Occupational Superannuation Standards Act 1987, even though it had not complied with the investment standard. On that basis the respondent conceded that the investment income derived by the Superannuation Fund during the 1987 year was exempt from income tax, i.e. that section 121CC had no application. As a consequence of that concession, the disqualifying event contained in sub-section 82AAC(3) ceased to exist and thus the further concession that the contributions made by the Company in the 1987 year were allowable deductions.
10. The Tribunal makes the following findings of fact which are not in dispute. The sole directors and shareholders of the Company are two brothers, B, who holds 9 shares, and C, who holds l share. The brothers were also full time employees of the Company and in that relationship it made the following contributions to the Superannuation Fund for their benefit:
1986 Year
on account B 5040
on account C 3040
-----
Total $8080
-----
1987 Year
an account B 5810
on account C 3857
-----
Total $9667
-----
The Tribunal also finds that during the years in question the Company occupied premises owned by a unit trust and in that regard paid rentals of $15,333 for 1986 and $25,000 for 1987.
11. The Tribunal further finds that the unit trust (``the Trust'') was founded by C on 31 August 1984 to carry on the activity of investment. It has a corporate trustee of which B is a director and shareholder. During the 1985 financial year the Trust acquired an option over certain lands and had erected thereon a building. It is this property that was leased to the Company and yet it seems that the tenancy arrangement commenced in the following year. The option was exercised in the 1985/86 year and payment was effected. The total consideration paid for the land and building amounted to $73,859, all of which had been funded by way of loans from B, C and the Company. As far as these references are concerned, it is significant that the Trust has not at any stage paid interest on those advances nor have the providers of those funds sought to charge interest.
12. The Trust has issued 200 units, 160 of which are held by the Superannuation Fund at an overall cost of $22,340. Although the remaining 40 units were registered in the name of B, as at 30 June 1986, it seems that C acquired 10 of those units in the following year.
13. Certain provisions of the trust deed relating to the income of the trust and the distribution of same are fundamental to an understanding of some of the submissions made and with that in mind they are recited hereunder-
``THE INCOME OF THE FUND
13.(a) The Trustee shall collect receive and get in all dividends interest rents and other income from the investments of the Trust Fund.
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(b) The Trustee shall pay out of the gross income of the Trust Fund all costs and disbursements commissions fees taxes (including land tax and income tax) management charges and other proper outgoings in respect of the investments and administration of the Trust Fund.
14.(a) The Trustee may at any time before the expiration of each Accounting Period until the Vesting Day determine with respect to all or any part or parts of the net income of the Trust Fund for such Accounting Period to do all or any of the following:
- (i) to pay apply or set aside the same for such of the Unit-holders for such interests and in such proportions and for one to the exclusion of the other or others of them as the Trustee may in its sole and absolute and unfettered discretion appoint;
- (ii) to accumulate the same;
- (iii) to pay apply or set aside the same for such charitable purposes as the Trustee (with the consent of the Unit-holders) may think fit.
(b) The following rules shall apply to any determination pursuant to paragraph (a) of this clause namely:-
- (i)...
- (ii)...
- (iii)...
- (iv) the Trustee shall have a complete discretion as to the making of any determination and shall not be bound to assign any reason therefor.
(c) The amount of any accumulation shall be dealt with as an accretion of the Trust Fund but so that the Trustee may at any time or times resort to all such accumulations and pay or apply the whole or any part or parts thereof as if they were income of the Trust Fund.
(d)...
(e) The Trustee shall hold so much of the net income of the Trust Fund for each Accounting Period as shall not be the subject of a determination effectively made at or prior to the end of such Accounting Period pursuant to the foregoing provisions of this clause in trust for the Unit-holders in proportion to the number of units of which they are respectively registered as holders on the last day of such Accounting Period.
(f) Any amount set aside for any Unit-holder and any amount held by the Trustee in trust for any Unit-holder pursuant to the foregoing provisions shall not form part of the Trust Fund hereof but upon such setting aside or becoming subject to such trust (as the case may be) shall be thenceforth held by the Trustee as a separate trust fund on trust for such person absolutely with power to the trustee pending payment over thereof to such person to invest or apply or deal with such fund or any resulting income therefrom or any part thereof in the manner provided herein.''
14. The 1986 income tax return of the Trust reveals rental income of $15,333, deductions of $2,671 and a net income of $12,662. It also appears that the trustee of the Trust abstained from making any determination pursuant to clause 14(a) of the deed and that as a consequence the provisions of clause 14(e) came into play, i.e. the net income was allocated to the unit holders in proportion to the number of units held. In accordance with that formula the share of net income allocated to the Superannuation Fund for this year was an amount of $10,129. The same procedure of allocation occurred in the 1987 year. After due allowance for a joint venture loss of $14,586, the net income for income tax purposes was a figure of $8,673 of which the Superannuation Fund's share was $6,939. It is important to observe that, notwithstanding the command contained in clause 14(f) of the deed that amounts set aside for unit holders be held as a separate trust, the amounts so determined were recorded in the books of the Trust as a credit to accounts titled ``Beneficiaries Loans''.
15. The respondent accepts that the amounts of rental charged by the Trust to the Company in the two years under review were commercially realistic.
16. The Tribunal finds that the Superannuation Fund was established on 17 January 1978 to provide benefits, pensions and retiring allowances for certain employees of the Company. To date, it appears that the only employees selected to benefit are B and C. The sole trustee of the Superannuation Fund is B.
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17. The following information has been extracted from the financial records and income tax returns of the Superannuation Fund in the hope that it will facilitate a better understanding of the matters in issue:
--------------
Revenue 1986 1987
Distribution from Trust 10,129 6,939
Interest received on Government
Bonds & Bank 1,034 1,470
------- ------
Total Revenue for Income Tax purposes $11,163 $8,409
------- ------
Assets
Loan -- Unit Trust 10,298 17,653
Units in Unit Trust 22,340 22,340
Government Bonds 5,760 5,760
Cash at Bank including Deposits 4,575 15,712
------- -------
Total assets $42,973 $61,465
------- -------
--------------
It is accepted that the balances shown under the heading of Loan represent the accounting equivalent of the amounts of net income allocated by the Trust to the Superannuation Fund over the two year period and the Tribunal so finds.
18. It is appropriate that the submissions of the respondent currently before the Tribunal be repeated in more specific detail:
- first, that the trustees of the Trust and the Superannuation Fund were not dealing with each other at arm's length inasmuch that B was the controller of both, and that because of that conjunction the share of net income from the Trust was excessive. In arriving at that latter view the respondent placed emphasis on the fact that B had advanced a considerable sum to the Trust on an interest free basis and that had a commercial rate been charged the Trust would have incurred a loss. Those conclusions, so it was said, resulted not only in a loss of the general exemptions contained in sections 23F and 23FC but also the application of the penalty tax rate of 50 cents to the income amounts of $10,129 and $6,939;
- secondly, that the loan of $10,298 from the Superannuation Fund to the Trust was one between the Superannuation Fund and an associate of the employer sponsor, i.e. the Company, and thus it came within the definition of ``in-house asset'' contained in sub-section 121C(1). Furthermore, that the in-house assets exceeded 10% of the cost of all the assets of the Superannuation Fund and accordingly it failed the test set out in section 121C(5). For those reasons the exemption previously afforded by section 23F is lost and the investment income is to be taxed in terms of section 121CC;
- thirdly, that bearing in mind the provisions contained in sub-section 82AAC(3) and the application of section 121CC to the investment income of $1,034, the Company is not entitled to a deduction of the contributions made to the Superannuation Fund in the 1986 year and which totalled $8,080.
In recognition of the notice issued by the Commission, the respondent concedes that the investment income of $1,470 derived during the 1987 year is exempt income in terms of section 23FC and that the superannuation contributions of $9,667 made during that same year are allowable deductions in terms of sub-section 82AAC(1).
19. The question of whether the units in the Trust constituted an in-house asset of the Superannuation Fund was not in contention. On the authority of
Charles v FC of T (1954) 10 ATD 328, it was agreed that the acquisition of units in a unit trust was an investment in the assets subject to the trust rather than an investment in the trust.
20. The representative for the applicants though accepting, for the purposes of sub- sections 23F(18) and 23FD(4), that the trustees of the Trust and Superannuation Fund were not at arm's length (and correctly so in the opinion of the Tribunal), contended that the income was
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not excessive. In his opinion the measure of excessiveness should be gauged against the gross income of the Trust, and it appears that such a view stems from the belief that a unit holder in a unit trust has a proprietary interest in the income of the trust as soon as it is derived, see p. 41 of the book Modern Trusts and Taxation by Grbich, Munn & Reicher. As it was agreed that the rental being charged by the Trust was commercially realistic, then, according to such an interpretation, the income derived was not greater than that which might have been expected had the parties been dealing with each other at arm's length. The Tribunal acknowledges ``immediate entitlement'' where the right to participate in the sharing of the income is absolute, and yet when this particular trust deed is scrutinised, see clauses 14(a) and (b)(iv), it becomes obvious that a unit holder may be excluded from a distribution of income where the trustee decides to exercise the powers comprised in those clauses either in favour of other unit holders or to accumulate the nett income. In that circumstance, the Tribunal rejects the suggestion that the Superannuation Fund had an interest in the rental at the point of its derivation.21. While the Act provides no definition of the word income, the Tribunal is of the opinion that the term should be considered in the context of the precise legislation being reviewed. Sub-sections 23F(18) and 23FC(4) refer to ``income derived by a superannuation fund''. As the income in question concerns distributions from a trust it is appropriate to turn to Division 6 of the Act which refers to Trust Income. Sub-section 97(1) makes it quite clear that a beneficiary of the kind now being considered shall include as assessable income the relevant share of net income. Net income is defined in sub-section 95(1) in the following manner:
```net income', in relation to a trust estate, means the total assessable income of the trust estate calculated under this Act as if the trustee were a taxpayer in respect of that income..., less all allowable deductions...''
The provisions of the trust deed for the Trust also confirm that the distributions to unit holders is of the net income.
22. It is the conclusion of the Tribunal that the phrase ``income derived by a superannuation fund'', in the context of benefiting from a trust arrangement, relates to a share of the net income and, furthermore, that in a determination of whether that ``income'' is greater than it should be, all of the transactions pertaining to gross revenue and expenditure require examination. Not to do so, is to ignore the two sides of the net income equation.
23. For an outlay of $22,340, the Superannuation Fund became entitled to amounts of income of $10,129 in 1986 and $6,939 in 1987. Those returns, in our opinion, are greater than those normally available. The Tribunal accepts that the abnormally high level of profitability by the Trust has been achieved because of the interest free loans by B and others and that the terms agreed upon were the result of the relationship existing between the parties. The Tribunal finds that the income derived from the Trust is greater than what might have been expected had the parties been dealing with each other at arm's length. For that reason the Tribunal finds the income amounts of $10,129 and $6,939 are not exempt from income tax.
24. The issue of whether the amount of $10,298, described in the records of the Superannuation Fund as a loan, should be treated as an in-house asset is now addressed. Despite the use of the word ``loan'' in its own records, the representative of the Superannuation Fund submitted that this was an error of classification. Having regard to clauses 14(b) and (f) of the trust deed, he contended that in reality the amount was held by the trustee of the unit trust upon a separate trust. If that distinction is made, the respondent is prepared to concede that the holding of that amount in a separate trust would fall outside the meaning of in-house asset.
25. The Tribunal accepts that the amounts allocated in terms of clause 14(f) of the trust deed were distributed by way of journal entries in the Trust records and that the accountant engaged to write up the accounting records of the Trust and the Superannuation Fund decided of his own volition to use the title of ``loan''. Furthermore, we accept that the question of how those allocations should be treated was not addressed by the parties and that the choice exercised by the accountant was one of convenience.
26. To be an in-house asset, the first requirement is that the asset must consist of either a loan to, or an investment in an employer sponsor of a superannuation fund or
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an associate thereof. The term loan is not defined in the Act but is defined in Chitty on Contracts, 1989, 26th edition at para. 3574:``Definition of loan. A contract of loan of money is a contract whereby one person lends or agrees to lend a sum of money to another, in consideration of the promise expressed or implied to repay that sum on demand, or at a fixed or determinable future time, or conditionally upon an event which is bound to happen, with or without interest. In many circumstances, the question whether a particular transaction is, in law a loan or not will be immaterial, since the transaction will take effect according to the intention of the parties, however the contract may be classified...''
27. The amount of $10,298 is an accumulation of the allocations made for the benefit of the Superannuation Fund. Those allocations were effected in terms of clause 14(f) and resulted in a settling of the beneficiaries to whom payments would eventually have to be made. It seems to us that the allocation does no more than bestow upon the beneficiary a right to demand and receive payment of the amount so allocated. The issue of the relationship between amounts allocated by a trustee and the relevant beneficiaries was described by McCarthy J, in
Commr of IR v Ward 69 ATC 6050, at p. 6071 in the following manner:
``I believe, too, that it is misleading to speak of debtor-creditor relationship. The rights of the beneficiaries here do not arise out of debt or contract. They arise out of the trusts created by the deed, and the beneficiaries are entitled to invoke the powers of the court by reason of a new title `consisting of the exercise of the trustees' discretion in the infant's favour.'''
28. The Tribunal is satisfied that the Superannuation Fund has not lent or agreed to lend a sum of money to the Unit Trust, nor was it the intention of the parties to treat allocations of net income as a loan. Neither did the $10,298 arise out of a debt or contract. In these circumstances the Tribunal concludes that the essential elements required of a loan are not present and for that reason it is a mistake to treat the $10,298 as a loan and thus it should be excluded from the in-house asset calculation. On that basis sub-section 121C(5) has no function and the investment income derived during the 1986 year is exempt from income tax. It follows that the restriction of deductibility on contributions contained in sub- section 82AAC(3) is removed and that the contribution of $8,080 made by the Company in the 1986 year is an allowable deduction.
29. Additionally, the Tribunal is of the view that the provision of clause 14(f) of the trust deed is binding authority on the trustee of the trust and that amounts set aside for any unit holder become the subject of a separate and distinct trust. That position may vary where the parties meet and come to some other agreement, but we accept that this has not occurred in these references. Nor do we believe that the making of a journal entry transferring the share of net income to an account titled ``Loan'' changes the trust arrangement to one of loan. The selection of a loan account to receive the allocation credit was not only in contravention of the deed but also lacked the authorisation of the parties. In terms of the respondent's earlier concession the money subject to the separate trust is not an in-house asset.
30. For the sake of completeness, the Tribunal offers the following comments on the issue of whether the trustee of the unit-trust - a separate company of which B was a director and shareholder - is an associate of the employer sponsor, i.e. the Company. The answer is to be found in an analysis of section 26AAB, especially sub-sections 26AAB(14)(b)(iii) and 26AAB(14)(b)(iv)(B). In a consideration of these provisions, it must be noted that the word ``taxpayer'' must be read as ``employer sponsor'' and that the expression ``trustee of a trust estate'' is a reference to the trustee and not some inexact application to the trust or to trust property - see comments of Burchett J in
Trevisan & Anor (Trustees of Forli Pty Ltd Superannuation Fund) v FC of T 91 ATC 4416 at p. 4421. The Tribunal finds that B holds 90% of the issued capital of the Company and that he is in a position to cast, or control the casting of, more than 50% of the maximum number of votes that might be cast at a general meeting of the taxpayer company and for that reason he is an associate of the Company. Furthermore, the Tribunal finds that B, as a unit-holder in the unit-trust, was capable of benefiting under the trust. Such a connection leads to the conclusion that the trustee of the unit-trust is an associate of the employer sponsor.
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31. Former section 223 states that additional tax of double the tax avoided shall be imposed where, inter alia, a taxpayer makes a false or misleading statement, which in turn leads to an avoidance of tax. Section 227 provides the respondent with the authority to remit all or part of that penalty. The Tribunal's attention was directed to the 1986 return of the Superannuation Fund and in particular to its failure to detail any ``Income (other than Dividends) Derived from Transactions not at arm's length'' and also the statement that the cost of its in-house assets was nil. It seems that these indiscretions caused the respondent to impose additional tax at 20% of the tax avoided. In view of our decision on the matter of in-house assets, the penalty applied to the tax levied on the investment income, i.e. 20% of $310.20 should be remitted. In all the circumstances the Tribunal considers the rate of 20% as being reasonable and sees no reason to make a further remission of the penalty applied to the non-arm's length income of $10,129. According to our calculations the new additional tax figure is $1,012.90.
32. For the reasons enunciated above the Tribunal varies the decision on the objections to the following extent-
- • the investment income of $1,034 and $1,470 derived by the Superannuation Fund during the 1986 and 1987 years respectively is exempt from income tax;
- • the additional tax imposed on the Superannuation Fund for the 1986 year be further remitted to an amount of $1,012.90; and
- • the contributions made by the Company to the Superannuation Fund in both years are allowable deductions.
In all other respects the objection decisions are affirmed.
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