Evidencing Arm's-Length Private Lending - SMSF Defends Against ATO NALI determination

In a recent Administrative Appeals Tribunal decision, a corporate SMSF trustee successfully appealed an ATO determination that interest paid to the SMSF on private loan arrangements was non-arm's length income (NALI) and therefore not exempt current pension income of the SMSF. The ATO had imposed penalties and issued amended assessments for the relevant years.

This case shows that proving that while it is difficult to overturn an ATO determination in relation to NALI is not impossible. The SMSF's evidence from independent experts, genuine commercial explanations for the SMSF's structure and investments, and practices of having engaged accountants to act for the relevant entities were important in establishing the validity of arm's-length dealings.

Background

The Applicant was a corporate SMSF trustee which derived income as a unit holder in a unit trust (JJ Unit Trust) during the income years of 2015, 2016, and 2017 (Relevant Years). 

The JJ Unit Trust loaned money to two related entities, ‘ABC’ and ‘DEF’ through a series of Loan Agreements: JJ Unit Trust loaned funds to ABC, which on-lent funds to DEF, and DEF in turn on-lent these funds to third parties. 

The parties agreed to a written resolution (Funding Resolution) which set out:

• the loan amount, originally lent by JJ Unit Trust to ABC, then from ABC to DEF;
• the interest rate payable by third parties on loans from DEF, which was set at the same rate of interest payable under the loans between DEF and ABC, and ABC and JJ Unit Trust;
• fees payable to ABC and DEF with respect to the third-party loan; and
• the security to be provided by third parties.

The interest income which JJ Unit Trust derived from these loans was distributed to the SMSF as JJ Unit Trust’s sole unitholder, and the SMSF treated it as ‘exempt current pension income’ (ECPI). However, the Commissioner of Taxation as respondent (ATO) determined that this income was NALI and should not have been included as ECPI. 

Non-Arm's Length Income

The primary issue was whether the relevant NALI provisions of the ITAA97  applied in respect of the distributions were made to the SMSF as the sole unitholder of JJ Unit Trust. 

The ITAA97 provided that income derived by an 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:

• the entity acquired the entitlement or income under a scheme in which the parties were not dealing with each other at arm’s length; and
• the amount of the income received was more than the entity might have been expected to derive if those parties had been dealing with each other at arm’s length.

Tribunal Decision

The Tribunal set aside the ATO’s determination and allowed the SMSF’s objection to the ATO’s amended tax assessments for the Relevant Years. Deputy President Molloy was satisfied by the SMSF’s evidence that the scheme between the parties was consistent with the terms of arm’s length dealings. 

Deputy President Molloy considered the following evidence which was provided in relation to the matter: 

• SMSF: the testimony of various solicitors and a finance broker with relevant expertise; and
• ATO: reports and testimony provided by a registered valuer which concluded that the SMSF was able to attain more income under this scheme than it would have received if it had loaned funds to unrelated companies under ‘a typical lending scenario’ (where there were interest rate margins between each lender in the chain). 

The ATO contended that because the same interest rate was applied to each of the loans, rather than ABC and DEF applying and keeping a margin , JJ Unit Trust derived more interest income under the scheme than it would have under a typical lending scenario. 

Despite the ATO’s arguments, the Tribunal was satisfied from the Applicant’s witness testimony that the scheme established under the loan facilities did not differ from what might be expected between independent parties dealing with one another in the private lending market. Further, based on the SMSF’s submissions , Deputy President Molloy was satisfied that the income received by the Applicant during the Relevant Years was not NALI, and was no more than one might expect to derive when dealing at arm’s length. 

Implications: How should SMSFs ensure they do not breach NALI rules?

SMSFs receiving sizeable income from related trusts should still expect scrutiny from the ATO, particularly where borrowing and lending is involved. However, this case provides guidance about what will be expected of an SMSF in attempts to evidence arms-length dealings in the context of private lending. 

SMSFs can attempt to safeguard their dealings by:

• Exhibiting clear and justifiable commercial reasons for their SMSF and investment structures;
• Being able to explain those reasons from the perspective of the controlling mind between the entities;
• Engaging relevant independent experts; and 
• Retaining accountants and solicitors to act for the relevant entities.

More information from Maddocks

For more information or to find yourself a trusted legal advisor to engage, contact Maddocks on (03) 9288 3555 and ask to speak to a member of the Commercial Practice Group.

More Cleardocs information on related topics 

You can read earlier ClearLaw articles on a range of topics including:

• ATO Takes Expansive Approach to NALI and CGT In New Determination
• NALE Quirks To Be Resolved By New Laws
• NALI Rules And The ATO’s Approach In Law Companion Ruling 2021/2

Order related document packages

• Superannuation Trust (SMSF)
• SMSF Set Up & Register Corporate Trustee
• Update to SMSF
• SMSF Pension Pack
• SMSF Minutes & Resolutions Package