A closer look at the arm’s length rules
While most practitioners are familiar with the ‘arm’s length rule’, many may be unaware of just how many of the SMSF rules rope in an arm’s length requirement.
Most advisers would be familiar with the requirement under s109 of the Superannuation Industry (Supervision) Act 1993 (Cth) that states investments by an SMSF trustee broadly must be made and maintained on an arm’s length basis (‘arm’s length rule’). While this represents an acceptable summary of the law, the intricacies of the section have proved more complicated.
In greater detail, the arm’s length rule states that parties to an investment transaction must deal at arm’s length, or if they do not deal at arm’s length, the terms of the transaction cannot favour the other party (the non-SMSF party) any more than what is reasonably arm’s length. This broadly suggests that an investment that favours the SMSF may be acceptable. However, for broader reasons discussed later, this is not fully accurate.
The second quirk in the arm’s length rule is that it says that if an SMSF trustee invests – and later during the term of the investment, the trustee is ‘required to deal’ with the other party that is not at arm’s length –the SMSF trustee must deal in the same manner as if the parties were at arm’s length. This might suggest that where an SMSF trustee invests in an entity that itself proceeds to deal in a way that is not arm’s length, the SMSF trustee may not be contravening the arm’s length rule because it is not being ‘required to deal’ with another party. In other words, the non-arm’s length dealing would be one step removed from the SMSF.
In the decision of Montgomery Wools [2012] AATA 61, an SMSF bought all the units in a unit trust. The unit trust essentially allowed its assets to be used to support a family business. The Administrative Appeals Tribunal took the view that because the SMSF only passively allowed the unit trust to operate in this way, the arm’s length rule was not contravened.
In particular, senior member J L Redfern stated:
- However, the wording of the subsection, which only applies if the trustee is ‘required to deal’, appears to be curiously narrow. The commissioner did not address this submission, although Montgomery Wools submitted that as a matter of statutory construction and on the facts of this case, s109(1A) simply did not apply.
- Even if I was of the view that ‘required to deal’ should be given a broad meaning to simply cover dealings with the related party investment by the trustee, Montgomery Wools was not required to deal with the units by reason of the events that took place in 2004. There was no sale of or dealing in the units, but rather the underlying investment owned by the MPT. It is not clear that this provision is intended to apply in these circumstances and in this regard I note that that this was one of the reasons why the in-house assets rules were amended in 1999.
- I, therefore, find that Montgomery Wools did not breach [the relevant part of the arm’s length rule] in 2004.
However, while the arm’s length rule was not contravened in Montgomery Wools, the sole purpose test was. That is, the actions were not caught by the narrower arm’s-length rule, but they were caught by the sole purpose test.
While an SMSF may sidestep certain laws on a technicality, there is a wide ambit in the sole purpose test that arguably captures broader non-arm’s length dealings. In fact, nearly all contraventions of the sole purpose test for SMSF investments arise where there are non-arm’s length dealings. This is partly how the concept of ‘arm’s length’ in practice pervades other compliance provisions.
The ATO has expressed disagreement with this aspect of Montgomery Wools in a decision impact statement that stated, “should a similar issue arise in the future, the ATO may seek to further clarify the application of subsection 109(1A) of the SIS Act”.
Lastly, the term ‘arm’s length’ is not defined in the SISA.
Adverse tax consequences for non-arm’s length dealings
The concept of arm’s length also arises in the context of non-arm’s length income. Broadly, s295-550 of the Income Tax Assessment Act 1997 (Cth) (ITAA 1997) states that income is non-arm’s length income if it is derived from a scheme where the parties were not dealing at arm’s length and the income derived by the SMSF is more than might be expected had the parties dealt at arm’s length.
Non-arm’s length income is taxed at a rate aligned with the highest marginal individual tax rate.
Accordingly, this pushes SMSFs towards ensuring their investments are at arm’s length. Non-arm’s length income also means that an SMSF is broadly not able to invest in a way that favours the SMSF and gives greater income to the SMSF than would be arm’s length, despite the quirks discussed in the arm’s length rules.
This arguably ensures SMSFs invest in a way that their income is neither too much nor too little, so as to comply with the arm’s length rule and not enliven non-arm’s length income.
The ITAA 1997 does not give detailed guidance on what arm’s length means in this instance, stating in s995-1: “in determining whether parties deal at arm's length, consider any connection between them and any other relevant circumstance”.
Non-geared unit trusts and companies
An SMSF is broadly able to invest in a unit trust or company that is controlled within the family group if the unit trust or company falls within the definition of what is informally called a ‘non-geared’ unit trust or company. More technically, these are unit trusts and companies to which regulation 13.22C of the Superannuation Industry (Supervision) Regulations 1994 (Cth) (SISR) applies. These investments will not be in-house assets. Most are aware that unit trusts and companies of this type are restricted and cannot borrow money, loan money to any entity or own any interest in another entity (such as shares or units), etc.
However, one feature that is sometimes forgotten is that any transaction that is not on an arm’s length basis will trigger the unit trust or company becoming an in-house asset. Once any of the specified trigger events such as this occur, the unit trust or company is tainted and can never again be excepted from being an in-house asset for that SMSF (regulation 13.22C(3) of the SISR).
Acquiring business real property and other assets from a related party
For the purposes of this article, a final area in which the requirement to deal at arm’s length arises is in s66 of the SISA, which states broadly that SMSF trustees must not intentionally acquire an asset from a related party. The most commonly known exception to this is that business real property (and certain other assets) can be acquired if the SMSF has fewer than five members and the business real property is acquired at market value. Market value is in turn defined to mean (s10 of the SISA) the amount that a willing buyer of the asset could reasonably be expected to pay to acquire the asset from a willing seller if the following assumptions were made:
(a) That the buyer and the seller dealt with each other at arm’s length in relation to the sale;
(b) That the sale occurred after proper marketing of the asset; and
(c) That the buyer and the seller acted knowledgeably and prudentially in relation to the sale.
The above is a very specific guide to follow in determining value, with only on aspect of it referring to the concept of arm’s length.
Conclusion
As the above provisions of the law demonstrate, the law and the interpretations of it have caused the idea of arm’s length dealings to be inescapable in adhering to superannuation law compliance. It is particularly important to note this in relation to the sole purpose test, which often causes trouble in interpretation.
David Oon, senior associate, and Gary Chau, lawyer, DBA Lawyers
