Non Arm’s Length Income

The primary issue, whether the NALI provisions apply, turned on s 295-550(5) of the ITAA 1997 which provides:

(5) Other income * derived by the 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:

(a) the entity 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

(b) the amount of the income is more than the amount that the entity might have been expected to derive if those parties had been dealing with each other at arm’s length.

The tribunal accepted that condition (a) was met. While there was no dispute that DEF was dealing with the third parties at arm’s length, the same could not be said of the dealings between JJUT, ABC and DEF. The directing mind of each of these entities, in relation to these dealings, was Mr. J.

Having been caught by this limb, the case essentially then turned on limb (b)…whether the amount of income is more than the amount that the entity might have been expected to derive if those parties had been dealing with each other at arm’s length.

Under the tax legislation, the burden of proof fell on the taxpayer. Under s 14ZZK of the Tax Administration Act, taxpayers who have an amended assessment issued to them by the Commissioner bear the burden of proving, on the balance of probabilities, that the amended or default assessment is both excessive AND what the assessment should have been.

To go about this, rather than looking for benchmarks, the taxpayer relied on expert evidence from individuals in the lending space – Mr. C, Mr. Gale and Mr. McLindin.

Mr. C is a solicitor. He gave evidence of what, in his experience, is industry practice. He explained the benefit of having at least one entity interposed between JJUT and the third-party borrowers. He and Mr Gale, a finance broker, gave evidence of similar fee structures to the JJUT/ABC/DEF structure.

Their evidence, independently of one another, was that the fees (including profit share and absence of interest margins) charged by DEF and ABC were commercial and consistent with what would have been earned by those parties if they had been dealing with each other at arm’s length.

The taxpayer’s other witness, Mr. McLindin, is also a solicitor. He gave evidence of private lending of which he had considerable knowledge and experience. Mr McLindin focused on the lending chain under consideration. He stated that funds flowing up and down the lending chain with the risk being shared was typical for on-lending arrangements of this sort. He said that ABC and DEF received rewards within the reasonable bounds acceptable within the commercial market.

For its part the ATO did not accept that Mr. McLindin was an independent witness, as he was also Mr. J’s solicitor. This line of argument was rejected. Instead, Mr McLindin impressed the tribunal as having the requisite expertise and experience to undertake the task of analysing this lending arrangement.

The tribunal did not detect anything in the content of Mr McLindin’s evidence, or in the manner in which he answered questions under cross-examination, to indicate that he had adopted anything like the role of advocate for the taxpayer whether consciously or subconsciously. He impressed the tribunal as “thoughtful, professional and objective”.

The gist of the ATO’s case was that no margin was charged on interest rates between the various lenders. It also contended that ABC’s fees were unsustainably low. By retaining all the interest for itself and paying ABC unsustainable low fees, the taxpayer thus ensured it earned more than it otherwise would have had the parties were dealing on an arm’s length basis.

The ATO’s main expert witness, Mr Wist, had been a registered valuer. While he had extensive experience in finance, the tribunal found that he did not have the significant exposure to private lending transactions comparable to Mr Gale, Mr C and Mr. McLindin. Mr Wist has substantial knowledge and experience in the field of lending, this mainly involved banks and other large lenders, but not so much in private lending. The tribunal said: “I am satisfied that Mr McLindin, Mr C and Mr Gale have much more knowledge and familiarity concerning the type of private lending arrangement with which I am concerned”.

In the end, the tribunal came down in favour of the taxpayer as follows:

I am satisfied the scheme established under the private lending facility did not differ from that which might be expected to have operated between independent parties dealing independently with one another in the private lending market at the time.

I am satisfied based on the evidence of Mr C, Mr Gale and Mr McLindin that JJUT did not derive income that was ‘more than the amount that the entity might have been expected to derive … when dealing at arm’s length. I am satisfied that the relevant interest income received by the applicant in the 2015, 2016 and 2017 income years was not NALI.

As per earlier, s 295-550(5) of the ITAA 1997 states:

(5) Other income *derived by the 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:

(a) the entity 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

(b) the amount of the income is more than the amount that the entity might have been expected to derive if those parties had been dealing with each other at arm’s length.

In determining whether a “scheme” was in play, the tribunal noted at paragraph 47 that: “the scheme, in my view, is the totality of the arrangement between JJUT, ABC, DEF and the third-party borrowers. I do not believe there is any disagreement between the parties on that”. This approach however was somewhat contradicted by the overall judgement by the tribunal which focussed on each aspect of the scheme – the interposed entities, the interest rate charged, the reason for the on-lending etc. – as though if any aspect was not commercial, then a scheme was at play.

If the tribunal really meant that it is indeed that the totality of the arrangement is the correct approach, the judgement would be significantly enhanced if after the quoted text at paragraph 47, it is clarified that: “This is in contrast to examining each aspect of the arrangement and requiring each aspect to be commercial rather than the overall arrangement itself”.

All told, the judgement is somewhat inadequate in the sense that while it gives SMSFs a favourable outcome, it doesn’t quite fully explain how it gets you there (do you take the whole of arrangement approach, or examine whether each aspect is commercial? Is the ATO’s benchmark approach relevant?). For this reason, it may be useful if the decision is appealed by the ATO to the Federal Court. Not only would the outcome then be binding (AAT decisions are technically not), but a fuller explanation of the approach to be taken may be offered by court.