Edited version of private advice

Authorisation Number: 1052250823319

Date of advice: 21 May 2024

Ruling

Subject: Non-arm's length income

Question

Will the SMSF's future receipt of fully franked dividends from Entity A result in non-arm's length income of the SMSF's under section 295-550 of the Income Tax Assessment Act 1997?

Answer

No

This ruling applies for the following periods:

Year ended 30 June 20XX

Year ended 30 June 20XX

Year ended 30 June 20XX

Year ended 30 June 20XX

Year ended 30 June 20XX

The scheme commenced on:

1 July 20XX

Relevant facts and circumstances

The Company is a proprietary limited company that carries on a business in Australia.

Family Trust A and Family Trust B each hold XX ordinary shares in the Company.

Due to growth in the business, the owners wish to bring in a third shareholder and director. As part of the restructure Family Trust A and Family Trust B will transfer their remaining shares to related SMSF's (SMSF A and SMSF B respectively).

As part of the restructure:

Family Trust A will dispose of XX ordinary shares

Family Trust B will dispose of XX ordinary shares

The proposed shareholdings of the Company after the restructure are as follows:

SMSF A - XX ordinary shares

SMSF B - XX ordinary shares

SMSF C - XX ordinary shares

The Company will have three Directors, each related to one of the SMSF's.

To facilitate the restructure, a third-party valuation has been obtained. The disposal and acquisition of the shares will be reflective of this valuation.

All ordinary shareholders are entitled to dividends on the same basis as all other ordinary shareholders.

None of the SMSF's will hold a controlling interest in the Company following the proposed restructure.

The controllers of each SMSF are not relatives of the controllers of the other SMSF's and are engaging with each other at arm's length for their respective SMSF's to invest in the Company.

The SMSF's and the Company are unrelated and the SMSF's members have formed independent decisions to invest in the Company due to the growth and long-term investment opportunity of the business.

The parties will enter into a written agreement to record the terms of the transfer of the Company's shares.

Assumptions

The ordinary shares in the Company will be acquired at a price that satisfies the ordinary meaning of market value.

In an income year the return on the ordinary shares in the Company represents a commercial and arm's length rate of return on the shares.

There will be no change to the rights attaching to any of the classes of shares in the Company.

There will be no shares issued in satisfaction of a dividend.

The Company will not derive income from parties as a result of any scheme the parties to which were not dealing with each other at arm's length.

The Company will not enter into any non-arm's length transactions that inflate the income of the Company that can be distributed to superannuation funds.

If any of the assumptions prove incorrect this is likely to impact the outcome and this Ruling should not be relied upon.

Relevant legislative provisions

Section 295-545 of the Income Tax Assessment Act 1997

Subsection 295-545(1) of the Income Tax Assessment Act 1997

Subsection 295-545(2) of the Income Tax Assessment Act 1997

Section 295-550 of the Income Tax Assessment Act 1997

Subsection 295-550(1) of the Income Tax Assessment Act 1997

Subsection 295-550(2) of the Income Tax Assessment Act 1997

Subsection 295-550(3) of the Income Tax Assessment Act 1997

Paragraph 295-550(3)(a) of the Income Tax Assessment Act 1997

Paragraph 295-550(3)(b) of the Income Tax Assessment Act 1997

Paragraph 295-550(3)(c) of the Income Tax Assessment Act 1997

Paragraph 295-550(3)(d) of the Income Tax Assessment Act 1997

Paragraph 295-550(3)(e) of the Income Tax Assessment Act 1997

Paragraph 295-550(3)(f) of the Income Tax Assessment Act 1997

Does Part IVA apply to this private ruling?

Part IVA of the Income Tax Assessment Act 1936 contains anti-avoidance rules that can apply in certain circumstances where you or another taxpayer obtains a tax benefit, imputation benefit or diverted profits tax benefit in connection with an arrangement.

If Part IVA applies, the tax benefit or imputation benefit can be cancelled (for example, by disallowing a deduction that was otherwise allowable) or you or another taxpayer could be liable to the diverted profits tax.

We have not fully considered the application of Part IVA to the arrangement you asked us to rule on, or to an associated or wider arrangement of which that arrangement is part.

If you want us to rule on whether Part IVA applies, we will need to obtain and consider all the facts about the arrangement which are relevant to determining whether Part IVA may apply.

For more information on Part IVA, go to our website ato.gov.au and enter 'part iva general' in the search box on the top right of the page, then select 'Part IVA: the general anti-avoidancerule for income tax'.

Reasons for decision

Non-arm's Length Income

Section 295-545 of the ITAA 1997 provides that the taxable income of a complying superannuation fund is split into a non-arm's length component and a low tax rate component. The note to subsection 295-545(1) explains that a concessional rate of tax applies to the low tax component, while the non-arm's length component is taxed at the highest marginal rate.

Subsection 295-545(2) of the ITAA 1997 provides that the non-arm's length component for an income year is the entity's non-arm's length income for that year less any deductions to the extent that they are attributable to that income.

Section 295-550 of the ITAA 1997 states:

1)    An amount of *ordinary income or *statutory income is non-arm's length income of a *complying superannuation entity if, as a result of a *scheme the parties to which were not dealing with each other at *arm's length in relation to the scheme, one or more of the following applies:

(a)  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 relation to the scheme;

(b)  in gaining or producing the income, the entity incurs a loss, outgoing or expenditure of an amount that is less than the amount of a loss, outgoing or expenditure that the entity might have been expected to incur if those parties had been dealing with each other at arm's length in relation to the scheme;

(c)   in gaining or producing the income, the entity does not incur a loss, outgoing or expenditure that the entity might have been expected to incur if those parties had been dealing with each other at arm's length in relation to the scheme.

This subsection does not apply to an amount to which subsection (2) applies or an amount *derived by the entity in the capacity of beneficiary of a trust.

2)    An amount of *ordinary income or *statutory income is also non-arm's length income of the entity if it is:

(a)  a *dividend paid to the entity by a *private company; or

(b)  ordinary income or statutory income that is reasonably attributable to such a dividend;

unless the amount is consistent with an *arm's length dealing.

3)    In deciding whether an amount is consistent with an *arm's length dealing under subsection (2), have regard to:

(a)  the value of *shares in the company that are assets of the entity; and

(b)  the cost to the entity of the shares on which the *dividend was paid; and

(c)   the rate of that dividend; and

(d)  whether the company has paid a dividend on other shares in the company and, if so, the rate of that dividend; and

(e)  whether the company has issued any shares to the entity in satisfaction of a dividend paid by the company (or part of it) and, if so, the circumstances of the issue; and

(f)    any other relevant matters.

The Commissioner has issued Taxation Ruling TR 2006/7 Income tax: special income derived by a complying superannuation fund, a complying approved deposit fund or a pooled superannuation trust in relation to the year of income (TR 2006/7) which refers to the now repealed section 273 of the Income Tax Assessment Act 1936 (ITAA 1936), concerning 'special income'. To the extent that section 295-550 of the ITAA 1997 expresses the same ideas as section 273 this ruling is also taken to be a ruling about section 295-550 of the ITAA 1997 (paragraph 1A of TR 2006/7).

General meaning of dealing at arm's length

In Federal Commissioner of Taxation v AXA Asia Pacific Holdings Ltd [2010] FCAFC 134 (AXA) Edmonds and Gordon JJ in their joint judgement summarised the case law at paragraphs 105 - 109, with respect to dealing at arm's length:

105 Any assessment of whether parties were dealing at arm's length involves "an assessment [of] whether in respect of that dealing they dealt with each other as arm's length parties would normally do, so that the outcome of their dealing is a matter of real bargaining": Trustee for the Estate of the late AW Furse No 5 Will Trust v Federal Commissioner of Taxation (1991) 21 ATR 1123 at 1132 per Hill J. The reference in Furse 21 ATR 1123 to "real bargaining" is significant. It focuses on actual dealing between the parties: see also Re Hains (deceased); Barnsdall v Federal Commissioner of Taxation (1988) 81 ALR 173. That is not surprising. It is the same mental process as that described by Griffith CJ in Spencer v The Commonwealth (1907) 5 CLR 418 at 432.

106 The question of whether parties dealt with each other at arm's length in respect of a particular dealing is one of fact in each case: Granby v Federal Commissioner of Taxation (1995) 129 ALR 503 at 507. What is required is that "parties to a transaction have acted severally and independently in forming their bargain": Granby 129 ALR 503 at 507. Put another way, it requires consideration of how "unrelated parties, each acting in his or her own best interest, would carry out a particular transaction": Australian Trade Commission v WA Meat Exports Pty Ltd (1987) 75 ALR 287 at 291.

107 Consistent with those principles, there is no presumption that parties at arm's length dealt with each other at arm's length: Hains 81 ALR 173 and Furse 21 ATR 1123 at 1132. Parties may be at arm's length generally yet not deal with each other at arm's length in respect of a particular matter: Re RAL and Federal Commissioner of Taxation (2002) 50 ATR 1076 at [45] - [51]. So, for example, even where parties to a transaction are at arm's length, they will not "be dealing with each other at arm's length in a transaction in which they collude to achieve a particular result, or in which one of the parties submits the exercise of its will to the discretion of the other, perhaps, to promote the interests of the other": Granby 129 ALR 503 at 507.

108 Similarly, where one party to a transaction seeks only an overall result and is indifferent to the outcome of a particular aspect on which the statute focuses, the parties will be found not to have dealt with each other at arm's length on that particular aspect: Collis v Federal Commissioner of Taxation (1996) 33 ATR 438 at 443...

109 In Baxter v Commissioner of Taxation (2002) 196 ALR 519, a sales tax case, Gyles J held that a lease devised in order to obtain a revenue advantage did not make it a non-arm's length transaction, "no matter how widely that concept is construed": at [38]...

Application of subsections 295-550(2) and (3) of the ITAA 1997

Subsection 295-550(2) of the ITAA 1997 deems that a dividend from a private company, or ordinary or statutory income that is reasonably attributable to that dividend, is non-arm's length income unless the amount is consistent with an arm's length dealing.

Subsection 295-550(3) provides 6 criteria that the Commissioner is to have regard to when considering whether the amount is consistent with arm's length dealings. They are considered below.

Value of shares and cost of the shares - Paragraphs 295-550(3)(a) and (b)

TR 2006/7 states:

•         The market value of the shares at the time they are acquired will be compared to the cost of the shares (paragraph 22).

•         If a superannuation entity acquires shares in a company for an amount less than the market value of those shares, this will be a significant factor in determining whether the payment of the dividend is consistent with an arm's length outcome. This will especially be the case where other shareholders in the company paid market value for their shares (paragraph 28);

The value of the shares was determined by an independent valuation. The shares will be purchased by the funds at their value based on this third-party valuation. All shares in the Company will be purchased for the same price.

Therefore, these factors support a conclusion that dividends from the Company shares will be consistent with an arm's length dealing for subsection 295-550(2) of the ITAA 1997.

Rate of dividend - paragraphs 295-550(3)(c) and (d)

TR 2006/7 states:

•         The rate of dividend will be considered in comparison with the rate of dividend paid on any other shares in the company which is considered under paragraph 273(2)(d) (paragraph 37).

•         Other relevant factors may also be taken into account in determining whether the payment of the dividend is consistent with an arm's length outcome (paragraph 39).

•         Where the shares in the private company are of different classes, differing rates of dividend to shareholders will be an unfavourable factor unless the rate of dividend reflects the level of investment risk and is consistent with an arm's length outcome (paragraph 40).

The Company will only have ordinary shares with the same rights. No differing classes of shares are on issue, nor will they be issued in the future. All shares will be held by the SMSF's (Fund's) in equal proportions. Consequently, the rate of dividend for each Fund will be the same. The return on the ordinary shares will be a commercial and arm's length rate of return on the ordinary shares. All ordinary shareholders are entitled to dividends on the same basis as all other ordinary shareholders.

Therefore, these factors support a conclusion that dividends from the Company shares will be consistent with an arm's length dealing for subsection 295-550(2) of the ITAA 1997.

Paragraph 295-550(3)(e)

Paragraph (e) requires the Commissioner to consider whether the Company has issued any shares in satisfaction of dividends or that it will issue any shares in satisfaction of any dividends.

The company has not done so and is not expected to do so. Accordingly, this paragraph is not relevant and will be a neutral factor in determining if any dividends paid will be non-arm's length income.

Other relevant matters - paragraph 295-550(3)(f):

TR 2006/7 states that the other matters that the Commissioner may consider relevant include:

•         the extent to which members who are at arm's length to the private company have an interest in the superannuation fund;

•         the relationship between the superannuation fund and the private company;

•         the relationship between the superannuation fund and any party with which the private company has dealings;

•         who the superannuation fund acquires the shares from and the circumstances of that acquisition; and

•         the rate of return on the superannuation fund's investment.

In the circumstances of this case:

•         Each Fund is related to a Director and holds or will hold shares in the Company. However, each of the Directors and their related Fund are at arm's length from the other shareholders in the Company. The Directors are unrelated to each other (whether in a familial context or otherwise) other than by way of their business dealings in relation to the Company.

•         None of the Funds will hold a majority interest in the Company and therefore will not be in a position to sufficiently influence the Company (including the payment of dividends).

•         The ordinary shares will be acquired by the Funds on the same terms on which the other relevant unrelated Funds are able to acquire ordinary shares.

•         The ordinary shares will be acquired by the Funds at a price that satisfies the ordinary meaning of market value.

•         The Company earns its income from providing equipment hire services to clients. The Company will not derive income from parties as a result of any scheme the parties to which were not dealing with each other at arm's length and the Company will not enter into any non-arm's length transactions that inflate the income of the Company that can be distributed to the Funds.

•         The return on the ordinary shares will be consistent with a commercial and arm's length rate of return for the particular investment.

These matters support a conclusion that dividends from the Company shares will be consistent with an arm's length dealing for subsection 295-550(2) of the ITAA 1997.

Conclusion

Having regard to the facts and assumptions and considering the matters listed in paragraphs 295-550(3)(a) to (f) of the ITAA 1997, the transactions involving the acquisition of shares by the Funds and the basis upon which dividends will be paid by the Company are consistent with arm's length dealings.

Therefore, the dividends paid by the Company on the ordinary shares for the period covered by this Ruling will not be non-arm's length income of the Fund under section 295-550(2) of the ITAA 1997.

However, if any of the assumptions prove incorrect this is likely to impact the outcome and this Ruling should not be relied upon.

Subsection 295-550(1) of the ITAA 1997

In GYBW and Commissioner of Taxation [2019] AATA 4262 at 124, the Tribunal observed:

... that it is difficult to conceive of circumstances where a dividend paid by a private company to a complying superannuation fund would not be non-arm's length income under s 295-550(2) yet constitute non-arm's length income for the purposes of s 295-550(1). Section 295-550(2) specifically addresses the situation in which a dividend is paid to a complying superannuation fund by a private company and unlike s 295-550(1) adopts the prima facie position that such income is "non-arm's length income" unless the amount of the dividend is consistent with an arm's length dealing, based on the factors set out in s 295-550(3). It is difficult to conceive of a situation in which a taxpayer is able to demonstrate that the prima facie assumption in s 295-550(2) is rebutted but at the same time fails to demonstrate that the amount of the dividend is not non-arm's length income for the purposes of s 295-550(1), which involves no prima facie assumption.

As such, where a dividend does not constitute non-arm's length income under subsection 295-550(2) of the ITAA 1997 it is accepted it cannot be non-arm's length income under subsection 295-550(1).

For the reasons given above dividends paid by the Company for the period covered by this Ruling will not be non-arm's length income of the Fund under section 295-550(1) of the ITAA 1997.