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Dealing at arm's length | s109 SIS Act | Arm's Length Transaction

1 June 2020Section 109 SIS Act | Arm’s Length Transaction

The requirement for trustees to "deal at arm’s length with the other party" is a key pillar of all SMSF transactions.


This rule ensures that SMSFs are not used to artificially enhance concessionally taxed superannuation benefits. However, even minor breaches or misunderstandings of this requirement can lead to inadvertent contraventions and trigger significant tax consequences, including the application of non-arm’s length income (NALI) provisions.


The scope of a commercially based transaction extends beyond just market valuations. It includes the terms, conditions, processes, and documentation—each of which should align with what would be expected in similar commercial transactions.


This article explains the concept of arm’s length dealings, drawing on key legislative provisions, ATO rulings, and published guidance.


Relevant Provisions


Section 109 SIS Act: The trustee of an SMSF must ensure that any investment transaction is conducted on an arm’s length basis, or on terms no more favorable to the other party than what would typically be offered in an independent, commercial transaction.


Section 295.550 Tax Act (NALI): When an SMSF enters into transactions on non-arm’s length terms, and as a result derives income greater than what it would have earned under normal arm’s length conditions, that income is classified as non-arm’s length income (NALI). This applies to both inflated income inflows (e.g., above-market rent) and reduced expenses (e.g., undercharged loan interest).


The NALI rules require the existence of a “scheme,” which is broadly defined and can include any structured arrangement or series of actions.

These provisions, along with the sole purpose test, form critical anti-avoidance measures for SMSF investments and income.


The ATO has flagged specific NALI risks, particularly when related parties are involved in transactions, such as SMSF-related property developments.


What Is Dealing at Arm’s Length?


1. The Parties Involved

The requirement to deal at arm’s length focuses on the nature of the transaction, not merely the relationship between the parties. However, when the parties are related—such as SMSF members, employers, or Part 8 Associates—there is a heightened expectation on the trustee to demonstrate that the transaction reflects arm’s length terms.


The ATO’s SMSFRB 2020/1 notes that an inference exists that related parties may not deal at arm’s length, though this assumption can be rebutted with appropriate evidence. This is consistent with TR 2006/7, which explains that a relationship of control or influence between the parties is a significant factor in determining whether dealings are at arm’s length but is not conclusive.


TR 2007/1 further clarifies that unrelated parties can deal on non-arm’s length terms, while related parties can deal on arm’s length terms if properly structured.


2. Meaning of “Arm’s Length”

The ATO provides several important interpretations of what constitutes an arm’s length transaction:

  • Commercial Basis: The transaction must reflect what an independent, prudent person acting in their own best financial interest would agree to under similar circumstances.

  • Independent Decision-Making: The transaction must involve genuine negotiation and bargaining between the parties (TR 2006/7).


The emphasis is on ensuring the terms and conditions reflect commercially acceptable standards, such that an objective observer would consider them reasonable.


3. Market Value Considerations

Market value plays a central role in ensuring that SMSF transactions are consistent with arm’s length principles.

  • Section 10 of the SIS Act defines market value as the price that a willing buyer and willing seller would agree upon, assuming both are acting prudently, knowledgeably, and independently after proper marketing of the asset.

  • The Explanatory Statement to the NALE Legislation provides further guidance, noting that market value can fall within a commercially acceptable range. For example, a related party loan may still be considered arm’s length if the interest rate falls within a band of rates offered in the broader market.


When determining market value, trustees can rely on independent professional valuations, ATO safe harbor guidelines for LRBAs, and comparable rates offered by banks or commercial lenders.


4. Documentation and Process

Proper documentation and implementation of transactions are essential to demonstrate arm’s length compliance. This includes legally binding agreements, trustee resolutions, and supporting documentation showing that the transaction aligns with the SMSF’s governing rules and investment strategy.


For example, a related party LRBA loan should include:

  • A legally binding loan agreement

  • Trustee resolutions approving the loan

  • Holding trust establishment documents

  • Evidence of regular repayments and documented follow-up actions for missed payments


The ATO’s SMSFRB 2020/1 highlights the risks of inadequate documentation, as seen in a case involving an SMSF owning units in a private unit trust leasing business real property to a related party. When the lease agreement expired without proper renewal, the property became an in-house asset, resulting in potential NALI consequences.


5. Record Keeping

The ATO stresses the importance of comprehensive record keeping to demonstrate compliance with arm’s length requirements. Trustees should maintain documentation that includes:

  • Evidence of how the transaction was negotiated and structured

  • Independent valuations and supporting documents

  • Confirmation that the arrangement aligns with the SMSF’s trust deed and investment strategy


Conclusion


SMSFs provide members with flexibility and control over their retirement savings, allowing them to customize their investment strategy and respond to changing market conditions. However, with this flexibility comes the responsibility to ensure that all transactions comply with regulatory requirements, including the arm’s length rule.


Proper documentation, independent valuations, and adherence to commercial terms help safeguard the fund’s compliance and prevent the application of punitive tax measures, ensuring that members retain the benefits of concessional tax treatment and long-term wealth accumulation.

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