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Edited version of private advice

Authorisation Number: 1051970218837

Date of advice: 7 April 2022

Ruling

Subject: Non-arm's length income

Question

Will the dividend income derived by the Fund on their ordinary shares in the Company be treated as non-arm's length income within the meaning of section 295-550 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

This private ruling applies for the following period:

Year ended 30 June 20XX to 30 June 20YY

The scheme commences on:

The day the ordinary shares are acquired by the Fund

Relevant facts and circumstances

Background

The Company is a proprietary limited company that carries on a commercial business in Australia (Subject Business).

The Subject Business was previously carried on by a partnership of individuals.

The Company was incorporated and purchased the Subject Business including its goodwill from the partnership of individuals at market value.

There are a number of directors of the Company (referred to as Principals):

There are currently a number of different shares on issue in the Company as follows:

•                    ordinary shares;

•                    A Class shares (comprising sub-classes of A class shares); and

•                    B Class shares (comprising sub-classes of B class shares).

The Principals currently hold A class shares in the Company. The ordinary shareholders of the Company and the B Class shareholders are the trustees of discretionary trusts that are established for the benefit of each of the Principals and their respective relatives and related entities.

The A Class and B Class shares exist solely for the purpose of providing compensation to the Principals for their service and as a manager of a team.

The Principals (and the Principals' respective related entities that hold shares in the Company) are at arm's length from each other. That is, they 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.

The Principals all work for the Company. However, the Principals are primarily involved in managing specialist teams in the business, attracting new work, dealing with ongoing client relationships and overseeing strategic issues for the Company.

The Principals are not paid salaries, wages or superannuation by the Company, but are compensated for their and their respective team's professional services and performance for the Company via dividends on the A and B class shares.

At the time of making the ruling application, the Company employs a number of other individuals in the business. All of these employees contribute to the financial performance of the Company.

The employees are all members of a team that is led, managed and supervised by the Principals.

Ordinary shares

In summary, the rights attaching to ordinary shares are:

1.1      The right to vote on a resolution of any and all matters concerning the Company;

1.2      The right to participate in an annual dividend declared and paid on ordinary class shares ranking equally with all other ordinary shares;

1.3      The right to repayment of the capital paid upon each ordinary share and to participate in the division of any surplus assets or capital profits of the company ranking equally with all other ordinary shares.

Ordinary shares are issued in accordance with a valuation formula set out in the Shareholders Agreement (Valuation Formula) as applied by the Company's external accountants and tax agents.

The Company has obtained an expert report (the expert report) which stated that the valuation formula is a common and generally accepted valuation method for privately owned small to medium sized enterprises with positive and generally relatively stable earnings and business goodwill like the Company.

A Class shares and B Class shares

In summary, the rights attached to A class shares and B class shares are:

1.4      the right to partake in any dividend declared on the particular class of shares (or particular sub-class) which is compensation for the relevant Principal; and

1.5      upon the winding up of the Company, the right to repayment of the capital paid upon the particular class of share held (but no right to surplus capital);

1.6      the shares are redeemable for $1.

Dividend policy

Turn up dividend - A Class Shares

Each income year, the Principals declare and pay a dividend to the holders of the A class shares comprised of a Turn-Up Dividend. All of the Principals will receive Turn-Up Dividends.

The Turn Up Dividend is a base figure determined by a remuneration committee, having regard to the performance of each Principal in managing their team.

Performance Pool Dividend - B Class Shares

Each income year, the Principals declare and pay a dividend to the holders of the A and/or B class shares comprised of a Performance Pool Dividend. The shareholders are only entitled to participate in the Performance Pool Dividend to the extent that the Principal and/or their related entity holds at least 50 ordinary class shares in the Company.

The Performance Pool Dividend is determined by a formula that takes account of objective financial criteria such as the Principal's supervisory fees for their team, gross profit contribution of their team to the Company, referral fees to other teams within the Company and other financial criteria contributing to the financial success of the Company.

The dividends paid on the relevant subclasses of the Class A and Class B shares in an income year with respect to a Principal will reflect the commercial return that the Principal would be objectively expected to derive for the services that their respective team performs for the Company having regard to their expertise, duties and responsibilities and regard to any retention incentives.

Ordinary Shares

The balance of any retained earnings or cash reserves payable after taking into consideration the payment of the Turn Up Dividend, Performance Pool Dividend and retention of funds for working capital requirements is payable to ordinary class shareholders as a return on investment. However, the precise amount is determined by the board of the Company.

Dividends on the ordinary class shares are expected to be declared in or around June of each income year and paid shortly thereafter in the following income year.

The expert report stated that the anticipated return on the ordinary shares in the Company will represent a commercial and arm's length rate of return.

Remuneration Committee

The Company's remuneration committee determines the amount of the Turn-Up Dividend and the Performance Pool Dividend. The committee comprises the current managing director, chief operations officer of the Company; and two (2) independent and qualified persons appointed by the Company from time to time.

Proposed acquisition of ordinary shares

It is proposed that the Fund will acquire ordinary shares in the Company.

The Principal related to the Fund will not individually (or together with their related entities) hold a majority interest in the Company and therefore will not be in a position to sufficiently influence the Company including in respect of the payment of dividends.

The relevant Principal in their capacity as a director in the Company will not be in a position to individually influence, or significantly affect the decision-making of the Company including with respect to the quantum and payment of dividends.

The members of the Fund are the Principal and their spouse. Their spouse does not work for the Company.

The price paid by the Fund for the ordinary shares will be the market value of the shares at the time of issue as determined under the Valuation Formula in the Shareholders Agreement.

The Fund will use its cash reserves to acquire the shares. The Fund has not borrowed money that will enable it to acquire the shares.

The subscription for shares by the Fund is consistent with its investment strategy and will be used to provide retirement benefits to its members.

Documents incorporated into Ruling

This scheme description incorporates, and should be read with, the following documents:

1.7      Shareholders Agreement;

1.8      Constitution of the Company;

1.9      Valuation report;

1.10    Expert report.

Assumptions

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

There will be no change to the way in which dividends are paid on the Class A and Class B shares. That is, in an income year the dividends paid on the relevant subclasses of the Class A and Class B shares in an income year with respect to a Principal will reflect the commercial return that the Principal would be objectively expected to derive for the services that their respective team performs for the Company having regard to their expertise, duties and responsibilities and regard to any retention incentives.

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.

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.

Reasons for decision

Summary

Having regard to the facts and assumptions, the dividend income derived by the Fund on their ordinary shares in the Company will not be treated as non-arm's length income within the meaning of section 295-550 of the Income Tax Assessment Act 1997 (ITAA 1997).

Detailed reasoning

Section 295-545 of the ITAA 1997 provides that the taxable income of a complying superannuation entity 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 Fund will purchase the ordinary shares at a price that satisfies the ordinary meaning of market value.

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).

There are shares of different classes on issue in the Company that will have differing rate of dividends so it is necessary to consider the circumstances regarding the different classes.

The A Class and B Class shares exist solely for the purpose of providing compensation to the Principals. The return on these subclasses of shares will, with respect to the relevant Principals, reflect the commercial return that the Principals would be objectively expected to derive for the services that their respective team performs for the Company having regard to their expertise, duties and responsibilities and regard to any retention incentives. There will be no change to the way in which dividends are paid on the Class A and Class B shares.

The return on ordinary shares will comprise a return on the investment in the Company and will be the balance of any retained earnings or cash reserves after taking into consideration the payment of the dividends on the Class A and Class B shares. 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 and to participate in the division of any surplus assets or capital profits of the company on winding up.

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

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.

Other relevant matters - 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.

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:

•        The Fund and the discretionary trust are related to the relevant Principal but the Principal and their related entities are at arm's length from the other shareholders in the Company. The Principals 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.

•        The relevant Principal will not individually (or together with their related related) 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 relevant Principal is remunerated via the relevant subclasses of Class A and Class B shares at a commercial rate that would objectively be expected to be derived for the services that their team performs for the Company having regard to expertise, duties and responsibilities and regard to any retention incentives.

•        The ordinary shares will be acquired by the Fund on the same terms on which the other relevant unrelated Principals and their relevant related entities are able to acquire ordinary shares.

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

•        The Fund will purchase the shares with its existing cash reserves.

•        The Company earns its income from transactions in the ordinary course of its business. 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 so that income can be distributed to superannuation 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 Fund 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.

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.

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