House of Representatives

Explanatory Memorandum

(Circulated by authority of the Minister for Housing and Assistant Treasurer, the Hon Michael Sukkar MP)

Chapter 2 - Non-arm's length income of superannuation entities

Outline of chapter

2.1 The amendments in Schedule 2 ensure that the non-arm's length income rules for superannuation entities apply in situations where a superannuation entity incurs non-arm's length expenses in gaining or producing the income.

2.2 All legislative references in this Chapter are to the ITAA 1997 unless otherwise stated.

Context of amendments

2.3 The purpose of the non-arm's length income provisions is to prevent the inflating of superannuation fund earnings through non-arm's length dealings, for example, schemes involving non-commercial arrangements that stream income to the superannuation fund. The strategy is used by some individuals to increase superannuation savings in a way that is not caught by the concessional contributions cap and non-concessional contributions cap (contribution caps).

2.4 The non-arm's length income provisions contained in section 295-550 are essentially a re-write of the former provisions in section 273 of the ITAA 1936, the purpose of which was stated in the Explanatory Memorandum to the Superannuation Legislation Amendment Act (No.2) 1999:

to prevent income from being unduly diverted into superannuation entities as a means of sheltering that income from the normal rates of tax applying to other entities, particularly the marginal rates applying to individual taxpayers.

2.5 The changes introduced by the Treasury Laws Amendment (Fair and Sustainable Superannuation) Act 2016 lowered the annual contributions cap and threshold at which high income earners pay Division 293 tax on their concessionally taxed contributions. This increases the incentive to engage in arrangements that have the effect of circumventing these restrictions upon the transfer of wealth into superannuation.

Operation of existing law

Summary

2.6 The purpose of the non-arm's length income provisions is to prevent the inflating of superannuation fund earnings through non-arm's length dealings.

2.7 The concept of 'non-arm's length' takes its ordinary meaning. In broad terms, the concept is interpreted as relating to transactions in which individuals or entities are not dealing with each other on a commercial, unrelated party basis. Parties do not have to be related to deal with each other on non-arm's length terms. Benefits they or others receive due to the transaction are considered relevant in determining whether a transaction is on arm's length, unrelated party terms.

2.8 The taxable income of a superannuation entity is generally taxed at 15 per cent. However, the non-arm's length component is taxed at the top marginal rate. This ensures that income derived from a transaction that is not on unrelated party, commercial terms does not receive concessional treatment in superannuation.

2.9 There may be a technical deficiency in the non-arm's length income provisions whereby non-arm's length expenses (including where no expenses are charged) result in income not being treated as non-arm's length income as intended. The amendments seek to remove any ambiguity in this respect and ensure that superannuation entities cannot circumvent the provisions by entering into schemes with non-arm's length expenditure (including where they do not charge expenses).

Detailed explanation

2.10 The taxable income of a complying superannuation fund, complying approved deposit fund or pooled superannuation trust (together, complying superannuation entities as defined in subsection 995-1(1)) is made up of two components - a low tax component which is taxed at 15 per cent and a non-arm's length component which is taxed at the top marginal rate.

2.11 The non-arm's length component for an income year is the amount of the fund's non-arm's length income less any deductions to the extent that they are attributable to that income (subsection 295-545(2)).

2.12 The low tax component of the fund's taxable income is the amount of the fund's taxable income remaining after deducting the non-arm's length component from its total taxable income (subsection 295-545(3)).

Non-arm's length income of superannuation entities

2.13 There are several categories of non-arm's length income, including:

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ordinary or statutory income derived from a scheme where the parties are not dealing with each other at arm's length and the amount of the income is greater than what it would have been had the parties been dealing at arm's length in relation to the scheme (subsection 295-550(1)).

The other types of non-arm's length income are:

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private company dividends (including income attributable to such dividends) unless the amount is consistent with an arm's length dealing (subsection 295-550(2)); and

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trust distributions:

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income derived as a beneficiary of a trust, other than because of holding a fixed entitlement (that is, discretionary trust distributions) (subsection 295-550(4)); and

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income derived as a beneficiary of a trust through holding a fixed entitlement to the income of the trust where the fund 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 the amount of the income is more than what might have been expected to derive if those parties had been dealing with each other at arm's length (subsection 295-550(5)).

Existence of a scheme, parties and dealings

2.14 In order for the non-arm's length income provisions relating to ordinary and statutory income to apply, the non-arm's length income must have been derived from a scheme, in relation to which the parties were not dealing with each other at arm's length.

2.15 A 'scheme' is broadly defined in subsection 995-1(1) to cover a range of transactions and formal or informal arrangements. While a scheme can be undertaken by a single party, the non-arm's length income rules require dealings between at least two parties, or a party acting in more than one capacity, because of the requirement that the parties to a scheme have not dealt with one another on an arm's length basis.

Amount of income

2.16 The legislation requires the identification of a specific amount of ordinary or statutory income that is non-arm's length income. This ensures that the consequences of an amount of income being non-arm's length income are restricted to that amount of income and any related deductions.

2.17 As stated above, non-arm's length income can be ordinary or statutory income. Statutory income includes amounts such as net capital gains or amounts obtained as a refund of franking credits by virtue of the application of the tax offset for imputation credits attaching to franked distributions.

2.18 There may be a technical deficiency in Subdivision 295-H, such that its operation in relation to non-arm's length expenses is ambiguous. These amendments remove any such ambiguity.

2.19 For example, in cases where a superannuation entity acquires assets at less than market value (through a scheme entered into on non-arm's length terms), it may not have been clear whether the ordinary and statutory income from these assets falls within the scope of the Subdivision in all cases.

2.20 Similarly, the application of paragraphs 295-550(1)(b) and 295-550(5)(b) may be ambiguous where expenses incurred by a superannuation entity in respect of an asset are not on arm's length terms, but the amount of ordinary income or statutory income from the scheme is the same as might be expected had the dealing been at arm's length. This may be the case, for example, where real property is acquired under a limited recourse borrowing arrangement and where the rent derived under the scheme is at market rates but the interest paid on the loan is not.

2.21 Finally, the current law may not apply to net capital gains in line with the policy intent of Subdivision 295-H. For example, a fund acquires an asset at less than its market value through non-arm's length dealings and then disposes of the asset for market value consideration. The resulting net capital gain may arguably be the same as the gain that would have resulted had the parties been dealing with each other at arm's length when the asset was acquired, due to the operation of the cost base market value substitution rules in section 112-20. This means that the current non-arm's length income rules may have no effect, even though the transaction diverts more wealth into the concessionally taxed superannuation entity than would have been possible had the relevant dealings been at arm's length.

Summary of new law

2.22 This Bill clarifies the operation of Subdivision 295-H to ensure that complying superannuation entities cannot circumvent the non-arm's length income rules by entering into schemes involving non-arm's length expenditure (including where expenses are not incurred).

2.23 The framework for the new non-arm's length income rules remains broadly the same:

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there must be a scheme; and

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the parties to the scheme must incur less (or nil) expenditure than would otherwise be expected if the parties were dealing with each other on an arm's length basis in relation to the scheme.

2.24 Expenses may be of a revenue or capital nature, in the same way that non-arm's length income may be statutory or ordinary income.

Comparison of key features of new law and current law

Detailed explanation of new law

Non-arm's length expenses of superannuation entities

2.25 The amendments remove any ambiguity about how Subdivision 295-H applies to income derived from schemes where the superannuation entity has incurred non-arm's length expenditure.

2.26 A new provision is added to ensure that a superannuation entity's non-arm's length income includes income where expenditure incurred in gaining or producing it was not an arm's length expense. This includes where no expense was incurred (but might be expected to have been incurred if the transaction were on arm's length terms). [Schedule 2, item 1, paragraphs 295-550(1)(b) and (c)]

2.27 While subsection 295-550(1) has been restructured as part of the amendments, the restructure does not affect the application of the provision to income that would have been captured as non-arm's length income prior to the amendments.

2.28 Specifically, the scheme requirement formerly located in paragraph 295-550(1)(a) is now included in the chapeau to the subsection, and the former requirement that an amount is non-arm's length income if it is more than the amount the entity might have derived on an arm's length basis in paragraph 295-550(1)(b) is now contained in paragraph 295-550(1)(a). [Schedule 2, item 1, paragraph 295-550(1)(a)]

Example 2.1 - non-arm's length expenses of a superannuation entity

An SMSF acquired a commercial property from a third party at its market value of $1,000,000 on 1 July 2015.

The SMSF derives rental income of $1,500 per week from the property ($78,000 per annum).

The SMSF financed the purchase of the property under limited recourse borrowing arrangements from a related party on terms consistent with section 67A of the SIS Act.

The limited recourse borrowing arrangements were entered into on terms that include no interest, no repayments until the end of the 25 year term and borrowing of the full purchase price of the commercial real property (i.e. 100 per cent gearing).

The SMSF was in a financial position to enter into limited recourse borrowing arrangements on commercial terms with an interest rate of approximately 5.8 per cent.

The SMSF has not incurred expenses that it might have been expected to incur in an arm's length dealing in deriving the rental income. As such, the income that it derived from the non-arm's length scheme is non-arm's length income. The rental income of $78,000 (less deductions attributable to the income) therefore forms part of the SMSF's non-arm's length component and is taxed at the highest marginal rate. However, there will be no deduction for interest, which under the scheme was nil.

Non-arm's length interest on borrowings to acquire an asset will result in any eventual capital gain on disposal of the rental property being treated as non-arm's length income.

Expenses relating to a superannuation entity as beneficiary of a trust

2.29 When a superannuation entity holds a fixed entitlement to the income of a trust and derives income as a beneficiary of that trust, non-arm's length expenses incurred in acquiring the entitlement or in gaining or producing the income result in the income forming part of the superannuation entity's non-arm's length component. [Schedule 2, item 2, paragraphs 295-550(5)(b) and (c)]

2.30 These changes ensure that the amendments apply consistently between the general non-arm's length income rules for the income directly derived by a superannuation entity and where the superannuation entity derives income through its fixed entitlement to the income of a trust.

Example 2.2 - unit trust

A retail superannuation fund trustee acquires units in a unit trust as a beneficiary with a fixed entitlement, but pays a substantially lower amount for the units than stated in the promotional material for the unit trust due to a scheme the fund has entered into with the broker.

In acquiring the entitlement to a share of the unit trust's earnings, the retail superannuation fund trustee did not incur expenditure it might have been expected to incur if dealing at arm's length with the broker in purchasing the units.

The income derived from the units would have been the same whether or not they were acquired under an arm's length transaction.

The amount earned is non-arm's length income of the retail superannuation fund.

Any net capital gain made on disposal of the units may also be non-arm's length income due to the amendments to subsection 295-550(1).

Non-arm's length schemes and internal arrangements

2.31 For the non-arm's length income rules to apply to a scheme, it is necessary that the parties to the scheme were not dealing with each other at arm's length. [Schedule 2, items 1 and 2, subsections 295-550(1) and (5)]

2.32 As noted above, the term 'scheme' is defined by subsection 995-1(1) and the concept of 'non-arm's length' takes its ordinary meaning.

2.33 The requirement that parties not be dealing with each other at arm's length means that the non-arm's length income rules do not apply in respect of a superannuation entity's arrangements that are purely internal. This is because an entity's internal functions are not undertaken with another party on any terms, non-arm's length or otherwise.

2.34 For example, an SMSF trustee may undertake book keeping activities for no charge in performing their trustee duties. Such internal arrangements are outside of the scope of the non-arm's length income rules as they do not constitute a scheme between parties dealing with one another on a non-arm's length basis.

2.35 In certain cases, the trustee of a fund may undertake particular activities in performing its duties or choose to outsource those functions to third parties (for example, if the fund had a real estate portfolio, the trustee may be able to manage the properties or contract the services of a real estate agent). The question of whether the non-arm's length income rules apply in respect of services or functions that are undertaken by the trustee depends on the capacity in which the trustee undertakes those activities.

2.36 As a general rule, the trustee of an SMSF is prevented from charging for the services or functions that it undertakes in its capacity as trustee by paragraph 17A(1)(f) of the SIS Act. Services of this kind do not involve a scheme between parties as they fundamentally relate to the trustee's obligations in respect of the fund.

2.37 If the trustee is not acting as a trustee but is instead providing services that are procured as a third-party, the non-arm's length income rules are intended to apply. Provided that the amount charged for any such services is not less than that which would be expected to be charged between parties dealing at arm's length, the dealings will not be subject to the non-arm's length income rules. In such cases, the trustee of an SMSF may also be prevented from charging any more than the arm's length price because of the regulatory requirements in the SIS Act (see section 17B of the SIS Act, which permits a trustee to charge up to an arm's length amount for duties or services performed other than in the capacity as trustee).

Attributing non-arm's length expenses to particular amounts of income

2.38 Where there is a scheme that produced non-arm's length income by applying non-arm's length expenses, there must also be a sufficient nexus between the expense/s and the income, that is, the expenditure must have been incurred 'in' gaining or producing the relevant income. This reflects the analysis that must be undertaken in determining whether an expense is deductible under section 8-1, or can be included in the entity's cost base for the transaction if the expense is of a capital nature (see below).

2.39 For example, where the non-arm's length expense is an interest payment, identifying the relevant amount of income should be relatively straightforward. That is because a superannuation entity can only borrow under limited recourse borrowing arrangements, which means that the borrowed funds must be used to acquire a single, separately identifiable asset (subsection 67A(1) of the SIS Act). Where such an asset is used in deriving assessable income (including any capital gain on disposal), the income so derived will be non-arm's length income (see the rental income in Example 2.1 above). However, income derived from other assets that the superannuation entity holds - for example, dividend income from publicly listed shares - would not be non-arm's length income merely because the superannuation entity incurred a non-arm's length interest expense under the limited recourse borrowing arrangements.

2.40 To calculate a superannuation entity's non-arm's length component (that is, the amount of taxable income that is taxed at the highest marginal rate), it is also necessary to identify any other deductions that are attributable to non-arm's length income. Those deductions may include the non-arm's length expense that caused an amount of an income to be non-arm's length income (in the foregoing example, interest expenses).

Non-arm's length capital expenditure that results in non-arm's length income

2.41 In some circumstances, non-arm's length capital expenditure can result in a superannuation entity earning non-arm's length income. Where a fund acquires an asset for less than market value through non-arm's length dealings, the revenue generated by that asset may be non-arm's length income, as well as any statutory income (that is, net capital gains) resulting from the disposal of that asset. [Schedule 2, item 1, paragraph 295-550(1)(b); item 3, subsection 295-550(7)]

2.42 This ensures that trustees of funds do not have an incentive to acquire assets at less than market value for the purpose of generating potentially significant ongoing amounts of income which would be sheltered from marginal rates of tax. It further ensures that such income cannot escape taxation entirely where the assets are held in the retirement phase (that is, the income would no longer be treated as exempt current pension income).

2.43 Section 66 of the SIS Act specifically prohibits the acquisition of assets by the trustee of a fund from related parties. However, there is no prohibition against a trustee of a fund acquiring business real property and listed securities from related parties at market value.

2.44 As such, if the trustee of a fund were to acquire an asset from a related party on non-arm's length terms (even when in contravention of section 66 of the SIS Act), any income that is generated from the asset would also be non-arm's length income.

2.45 A superannuation fund may acquire an asset by purchasing an asset or by way of an in-specie contribution. Where a superannuation fund purchases an asset at less than market value or reports the in-specie contribution at less than market value, then the acquisition may form part of a non-arm's length scheme such that any ordinary or statutory income derived from the asset and the disposal of the asset will be treated as non-arm's length income.

2.46 The market value substitution rules in section 112-20 may apply in respect of an asset that is acquired by a superannuation fund under a scheme that is subject to the non-arm's length income rules. The market value substitution rules adjust the first element of the cost base and reduced cost base of a CGT asset that is acquired by an entity to the market value of the asset.

2.47 The non-arm's length income rules continue to apply to an asset that has its cost base increased by the market substitution rule. This approach reflects that both sets of rules may apply as a consequence of an asset being acquired at a non-arm's length price.

2.48 For example, where real property is acquired (not as a contribution) by the fund for less than market value as part of a scheme where the parties were not dealing at arm's length, any income generated from that asset (for example, rental income) will be non-arm's length income. When the property is ultimately disposed of, the resulting capital gain will also be non-arm's length income. However, in calculating the resulting capital gain, the market value substitution rule may apply such that any capital gain on the disposal of the asset is reduced as a result of the asset's increased cost base to the market value at the time of acquisition.

Range of transactions may be on arm's length terms

2.49 It can be difficult to determine an exact price that is 'non-arm's length'. An 'arm's length' price may be accepted to fall within a range of commercial prices. For example, loans may be available at different interest rates based on a range of factors. Accordingly, an SMSF may be able to apply an acceptable commercial rate of interest to a loan within a band of rates available to it on an arm's length basis.

2.50 In other circumstances, parties may enter into arrangements that result in discounted prices or favourable terms. This could occur where a party operates on simple cost-recovery basis for particular services but is able to justify doing so in commercial terms because of the economies of scale it achieves within its business by providing other services. For example, where services are provided to a large APRA fund either by the trustee acting in a separate capacity or by a related third party.

2.51 Transactions that are on arm's length terms, for example, borrowing arrangements financed by Authorised Deposit-taking Institutions and other commercial lenders or that meet the safe harbour terms in ATO Practical Compliance Guideline PCG 2016/5 are not impacted by these amendments.

Application and transitional provisions

2.52 The amendments made by this Schedule apply in relation to income derived in the 2018-19 income year and later income years, regardless of whether the scheme was entered into before 1 July 2018. [Schedule 2, item 4]