New SMSF case demonstrates how not to have non-arm’s length income

A recent AAT decision illustrates the sorts of evidence that might be necessary in order for an SMSF to not have non-arm’s length income (NALI). Accordingly, advisers working with SMSFs should pay close attention to this decision and the evidence that an SMSF should collect and retain.

The decision is BPFN and Commissioner of Taxation (Taxation) [2023] AATA 2330 and the full text is available at http://www.austlii.com/au/cases/cth/AATA/2023/2330.html

Facts

WARNING: The following are over-simplified facts. Do not rely on these facts. Instead, see the full text (hyperlink above).

Mr J was the member of an SMSF.

The SMSF was the sole unit holder of a unit trust. Mr J was the directing mind of the unit trust.

The unit trust lent money to a related entity referred to as ABC. Mr J was the directing mind of ABC.

ABC then on-lent to a related entity referred to as DEF. Mr J was the directing mind of DEF.

DEF then on-lent to independent third parties who undertook development activities.

The decision does not mention the size of the loans. However, they must have been substantial because the interest earned by the unit trust was as follows:

Interest (approx)

• FY2015: $1.2 million
• FY2016: $3.9 million
• FY2017: $2.6 million

The interest rate that the unit trust charged ABC was the same as the interest rate that ABC charged DEF, which was the same as the interest rate that DEF charged on its loans to the independent third parties. However, ABC and DEF did make a modest amount of ‘handling’ profit by charging certain fees on the loans. For example:

for a loan amount of $725,000.00, DEF would receive and retain an establishment fee ($11,962.50), a mortgage sale fee (if a mortgagee sale occurs) ($36,250.00), and a discharge fee ($500.00/lot, anticipated to be 26 lots = $13,000.00). ABC would be entitled to an amount of 0.5% of the loan amount upon either discharge of the mortgage or repayment of the loan from DEF.

DEF appears to have secured its loans to the independent third parties with first or second mortgages. However, the unit trust only had a guarantee from Mr J and an unregistered charge.

ATO’s audit

The ATO audited the SMSF and determined that the SMSF’s income received from the unit trust was NALI.

The key question was whether the amount of the income was more than the amount that the SMSF ‘might have been expected to derive if those parties had been dealing with each other at arm’s length.’

The crux of the ATO’s case was that:

… no margin was charged on interest rates between the various lenders. He also submitted that ABC’s fees were ‘unsustainably low’. The respondent submitted that by keeping all 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.

How the SMSF successfully defended itself

Firstly, remember that unlike criminal law, where you are innocent until proven guilty, in taxation law, you are guilty until proven innocent. More specifically, the ATO can amend an assessment and then it is the taxpayer who ‘has the burden of proving … that the assessment is excessive or otherwise incorrect and what the assessment should have been’ (see ss 14ZZK and 14ZZO of the Taxation Administration Act 1953 (Cth)).

Accordingly, having the right evidence is critical.

Mr J gave evidence himself. So did Mr J’s long-standing accountant and solicitor. Mr J explained to the AAT’s satisfaction that both his reasons and, the reasons of his accountant, for interposing ABC and DEF.

Contemporaneous documents were also important to the AAT (see paragraph 41 of the decision). However, the decision does not expressly describe what those documents were. Potentially they were loan documents and resolutions.

The SMSF also adduced evidence from:

• a finance broker (Mr Alan Kenneth Gale) who gave evidence of similar fee structures to the unit trust/ABC/DEF structure; and
• a solicitor with considerable knowledge and experience with private lending (Mr Liam Ross McLindin).

In light of this evidence, the AAT was ‘satisfied that the relevant interest income [distributed to the SMSF by the unit trust] in the 2015, 2016 and 2017 income years was not NALI’.

Implications

An SMSF receiving sizeable income from a related trust or company should expect ATO scrutiny.

The SMSF will have the burden of proving that the income is consistent with an arm’s length dealing. This practically means that the SMSF will have the burden of proving that each step in the chain is consistent with arm’s length dealings.

Discharging this burden can be difficult. However, it is not impossible.

This burden can be discharged by evidence from:

• independent relevant experts;
• sensible explanations from the ‘controlling mind’ between the entities; and,
• accountants and solicitors acting for the entities.

The SMSF should have sound commercial reasons for their structures and those reasons should be capable of explanation to third parties.

Contemporaneous written advice from solicitors with experience in areas such as NALI and SMSF laws can be very helpful.

The SMSF should ensure that each step is properly documented (eg, contemporaneous written loan agreements and any benchmark evidence of the amount charged, etc).

Naturally, DBA Lawyers is pleased to assist.

SISA and SISR issues not considered in BPFN

This decision only considered taxation issues, principally, NALI. It did not consider any issues under the Superannuation Industry (Supervision) Act 1993 (Cth) (SISA) or the Superannuation Industry (Supervision) Regulations 1994 (Cth) (SISR).

One unanswered question is why the SMSF’s investment in the unit trust did not constitute an in-house asset. Potentially, the answer is because the investment was a pre-99 excepted investment. (That is, excepted under ss 71A and 71D or 71E of the SISA.) However, the full text merely states the SMSF ‘has been the sole unitholder of [the unit trust] since at least 2006.’

Any SMSFs with similar structures should ensure that — in addition to addressing potential NALI exposures — they have complied with the in-house asset rules (and all the other SISA and SISR rules too). BPFN should not be misinterpreted as suggesting that this investment will always comply with:

• the in-house asset rules; and,
• the rest of the SISA and the SISR rules.

Valuing units

We have come across many situations where SMSFs investing in unit trusts have paid $1.00 per unit over many years despite the net tangible assets of the unit trust, especially if real estate property, having increased significantly over that period. This type of situation may give rise to NALI risks and should be reviewed.

Related articles:

For related information and articles:

• NALI advice
• Draft legislation issues on proposed NALE changes

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This article is for general information only and should not be relied upon without first seeking advice from an appropriately qualified professional. The above does not constitute financial product advice. Financial product advice can only be obtained from a licenced financial adviser under the Corporations Act 2001 (Cth).

Note: DBA Lawyers presents monthly online SMSF training. For more details or to register, visit www.dbanetwork.com.au or call 03 9092 9400.

For more information regarding how DBA Lawyers can assist in your SMSF practice, visit www.dbalawyers.com.au.

By Bryce Figot ([email protected]) Special Counsel and Daniel Butler ([email protected]) Director, DBA Lawyers.

DBA LAWYERS

16 August 2023