The impact of this case on ATO policy is discussed in Decision Impact Statement: Darrelen Pty Ltd, Trustee of the Henfam Superannuation Fund v. The Commissioner of Taxation (NSD 1079 of 2009 ).
DARRALEN PTY LTD AS TRUSTEE OF HENFAM SUPERANNUATION FUND v FC of TJudges:
Full Federal Court, Sydney
MEDIA NEUTRAL CITATION:
 FCAFC 35
Stone, Edmonds and Jagot JJ
1. This is an appeal from a decision of the Administrative Appeals Tribunal ("the Tribunal") affirming an objection decision disallowing objections against notices of amended assessment for the years ended 30 June 2000 to 2003 inclusive ("the relevant years of income").
2. The appellant is the trustee of the Henfam Superannuation Fund ("the Fund"). In each of the relevant years of income, the Fund was a complying superannuation fund.
3. In each of the relevant years of income, the trustee of the Fund was paid dividends on shares it held in Vercot Pty Limited ("Vercot"), a private company in relation to each of those years.
4. The only issue in this appeal is whether the Tribunal erred in deciding that the respondent ("the Commissioner") did not err in declining to exercise his discretion, pursuant to subs 273(2) of the Income Tax Assessment Act 1936 (Cth) ("the 1936 Act"), not to treat the dividends as special income of the Fund.
5. The underlying facts were not in dispute.
6. On 10 October 1995 the trustee of the Fund acquired from an existing shareholder four shares (of the 100 on issue) in Vercot for $51,218. Vercot was a passive holding company that held 25,609,320 shares in Abigroup Limited ("Abigroup"), a listed public company. The listed market value of each Abigroup share was $0.58 per share.
7. The acquisition had the effect that the Fund obtained an indirect interest in 1,024,373 shares in Abigroup, the market value of which on the date of acquisition was $594,136. The result was that the market value of the Fund's shareholding in Vercot, both when it was acquired and thereafter (and during the relevant years of income), was far in excess of the amount paid for it; the price was about 10% of the market value and between 1/10th and 1/6th of the true value.
8. Abigroup paid substantial dividends to Vercot, which in turn paid dividends to its shareholders including the trustee of the Fund; the dividends in each of the relevant years of income were far in excess of the purchase price which the trustee of the Fund had paid for the shares. In this regard, against an acquisition cost of $51,218 (paid in October 1995), the trustee of the Fund received dividends as follows: in the year ended 30 June 1996 - $26,400; in 1997 - $208,136; in 1998 - $140,000; in 1999 - $125,200; in 2000 - $143,720; in 2001 - $143,720; in 2002 - $86,320 and in 2003 - $76,640.
9. On the other hand, all dividends paid by Vercot on its shares in each of the relevant years of income were paid pari passu at the same rate, so that each shareholder (including the trustee of the Fund) received dividends in amounts equal to the proportion that the number of shares held bore to the total number of issued shares in Vercot.
10. During the years of income, subs 273(1) - (4) of the 1936 Act provided:
- "(1) This section applies to income derived in a year of income by a fund or unit trust (in this section called the ' entity ') that is a complying superannuation fund, a complying ADF or a PST in relation to the year of income.
- (2) A dividend paid to the entity by a company that is a private company in relation to the year of income of the company in which the dividend was paid is special income of the entity unless the Commissioner is of the opinion that it would be reasonable not to treat the dividend as special income of the entity, having regard to:
- (a) the value of the shares in that company that are assets of the entity;
- (b) the cost to the entity of the shares on which the dividend was paid by the company;
- (c) the rate of the dividend paid to the entity by the company on the shares in the company that are assets of the entity;
- (d) whether the company has paid a dividend on other shares in the company and, if so, the rate of that dividend;
- (e) whether any shares have been issued by the company to the entity in satisfaction of, or of a part of, a dividend paid by the company and, if so, the circumstances of the issue of those shares; and
- (f) any other matters that the Commissioner considers relevant.
- (3) For the purposes of subsection (2), income that, in the opinion of the Commissioner, was derived by the entity indirectly from a dividend paid by a company, being a private company in relation to the year of income of the company in which the dividend was paid, shall be deemed to have been a dividend paid to the entity by the company.
- (4) Income (other than a dividend to which subsection (2) applies or income derived by the entity in the capacity of beneficiary of a trust estate) derived by the entity from a transaction is special income of the entity if the parties to the transaction were not dealing with each other at arm's length in relation to the transaction and that income is greater than the income that might have been expected to have been derived by the entity from the transaction if those parties had been dealing with each other at arm's length in relation to the transaction."
11. As previously mentioned, in each of the relevant years of income Vercot was a private company and the Fund was a complying superannuation fund. Therefore the effect of s 273 is that the dividends paid to the Fund in each of those years were special income of the Fund in the absence of the Commissioner, having regard to the matters listed in paras (a) to (f) inclusive of subs 273(2), declining to exercise his discretion not to treat the dividends as special income.
12. In the relevant years of income, the taxable income of a complying superannuation fund consisted of two components: a standard component (s 285 of the 1936 Act) taxed at the concessional rate and a special component (s 284 of the 1936 Act) taxed at the non-concessional rate: s 26(1) of the Income Tax Rates Act 1986 (Cth). Section 284 identified "special income" as falling within the special component.
The Commissioner's objection decision
13. In reaching his objection decision the Commissioner considered each of the matters in paras (a) to (f) of subs 273(2). His conclusion on each, and the process of reasoning by which he got there are paraphrased, from his Reasons for Decision, below.
Value of the shares that are assets of the entity - para (a)
14. The Commissioner's position was that the reference to "value" was a reference to the market value of the shares in Vercot at the time of their acquisition. However, no finding of that market value was made under this head. The Commissioner noted that the four shares in Vercot had been acquired by the trustee of the Fund from another shareholder for $51,218.64, that all the 100 issued ordinary shares were fully paid shares and that the same dividend amount was paid to the holder of each share. The Commissioner then concluded: "[i]t is considered the facts for this matter do support the Commissioner exercising his discretion under subs 273(2) ...".
The cost to the entity of the shares on which the dividend was paid - para (b)
15. The Commissioner's position was that this matter entitles him to compare the cost of the shares with their market value at the date of acquisition and he noted that that cost was significantly less than their market value at the date of acquisition which he found to be $594,136. His position was encapsulated in the following paragraphs:
"Where shares are acquired at less than market value, an implication may be drawn that one of the intentions of the entity in acquiring the shares was to enable the entity to derive dividend income greater than would be the case if all parties were dealing at arm's length and dividends paid are likely to be considered as special income.
A conclusion to be drawn from the above is that the transaction has provided an opportunity for concessional taxation treatment to income that would otherwise be attributed to a high rate taxpayer.
It is considered that the cost of the shares in the private company does not reflect the true value or full market value of the shares. Therefore, it is considered the facts for this matter do not support the Commissioner exercising his discretion under subs 273(2) ..."
The rate of the dividend paid to the entity on the shares that are assets of the entity - para (c)
16. The Commissioner's position was that this matter entitles him to look not only at the rate of dividend, but to the rate of return on the investment and that as such he is entitled to have regard to the original cost of the shares and the value of the shares in deciding whether the rate of the dividend is consistent with an arm's length outcome. He noted that the rates of return for the relevant years of income ranged from 149.63% (2003 year) to 280.6% (2000 year). Having regard to these exceptionally high rates of return, and taking into account the value of the imputation credits, he concluded that this factor was unfavourable to him exercising his discretion.
Whether the company has paid a dividend on other shares in the company, and if so, the rate of that dividend - para (d)
17. The Commissioner's position on this matter was that as all shareholders received the same rate of dividend per share, it should be regarded as a neutral factor.
Whether shares have been issued in satisfaction of a dividend and the circumstances of issue - para (e)
18. As no shares have been issued by Vercot in satisfaction of all, or part, of a dividend, the Commissioner's position was that this matter did support the Commissioner exercising his discretion under subs 273(2).
Any other matters the Commissioner considers relevant - para (f)
19. The Commissioner noted the matters referred to in para 54 of TR 2006/7, namely:
- • 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 had dealings.
- • Who the superannuation fund acquires the shares from and the circumstances of that acquisition.
20. The Commissioner made the following further observation:
"A further matter to be considered is whether the fund is dealing at arm's length with Vercot. From the information provided, the answer to this would be no. If the fund were dealing at arm's length with Vercot, the fund would have paid market value for the shares it acquired. This factor would be unfavourable to the exercise of the Commissioner's discretion."
21. Finally, the Commissioner concluded:
"The matters under paragraphs (a) and (e) of [subs] 273(2) ... [are] favourable, while the matter under paragraph (d) is neutral. The matters in paragraphs (b), (c) and a part of paragraph (f) were unfavourable and it is considered these were sufficient to outweigh those in the former paragraphs.
Accordingly, the private company dividends paid to the Henfam Superannuation Fund from Vercot ... for the years ended 30 June 2000 to 30 June 2003 are to be treated as special income of the fund."
The appellant's argument before the Tribunal
22. The thrust of the appellant's argument before the Tribunal, as it was before this Court, is that the Commissioner erred in having regard to the circumstances pertaining to the Fund's acquisition of the four shares in Vercot in 1995 and, in particular, to the fact that they were acquired for a cost far below their market value. It was contended that it would not have mattered if the price for the shares had been less, or even if they were gifted to the Fund. According to this argument, what mattered was what happened in the year or years in which the dividend income was derived, not, if it be different, as it was in this case, what happened in the year of acquisition.
23. Underlying this argument was that, properly construed, s 273 is not concerned with non-arm's length arrangements concerning the acquisition of the shares, but only with non-arm's length arrangements concerning the derivation of the dividend income; and if dividends are paid on all shares in the company, including those owned by the Fund, on a pari passu basis without preference of any kind, the policy underlying the exercise of the Commissioner's discretion not to treat the dividend as special income of the Fund necessarily is satisfied.
The Tribunal's decision
24. The Tribunal did not accept this argument. At  of its reasons it said:
"[It was] argued that if this decision is against the Applicant, the 'tainting effect' arising from the acquisition of the relevant shareholding for much less than market value must have the effect that that tainting effect endures indefinitely, and that this consequence could not have been intended. On the basis that a consideration of section 273 may arise in respect of years subsequent to the relevant years the effect which is feared by the Applicant may be realistic but that is the effect of the section as drawn. ..."
And at  it said:
"The Tribunal agrees ... that paragraph (f) does compel a consideration of market value and more particularly that market value is not, as ... contended, irrelevant. Put in other words, the underlying transaction ... which gave rise to the relevant dividends cannot be divorced from the dividends themselves in the manner for which the Applicant contends and must form part of the factual matrix to be considered in relation to the question of whether the discretion can or should be exercised."
25. The Tribunal's conclusions on the matters to which regard is to be had under subs 273(2) are encapsulated in  to  of its reasons:
- (1) The reference to "value" in para (a) was, the Tribunal considered, for "historical reasons", a reference to "paid up value or par" not market value (at ).
- (2) The reference to "cost" in para (b) "means that it must be taken into account as a relevant factor and as part of the overall deliberation". According to the Tribunal, that will require a consideration, by way of comparison with, inter alia, market value (at ).
- (3) The Tribunal agreed that the rate of dividend was such that "all shareholders in the private company were treated on a pari passu basis". However, in the Tribunal's view, the term "rate" can refer to rate of return and the rate of return was unquestionably enormous in all relevant years; in excess of 100% of cost (at ).
- (4) The relevance of para (d) is limited even though it must be compared with para (c) given that all shareholders in Vercot received dividends at the same rate (at ).
- (5) Paragraph (e) is not apposite (at ).
- (6) In relation to para (f), the Board of Review cases were correctly decided even though there was in some instances a lack of detailed reasoning (at ).
The appellant's argument in this Court
26. The focus of the appellant's argument in this Court was, as indicated in  above, similar to the thrust of its argument before the Tribunal. According to the argument, the circumstances of the acquisition of the Vercot shares, including their cost and value, are not required to be ignored; but they will be relevant only if they assist with the proper inquiry. If the dividends are found to be at arm's length, the proper (that is, permissible) inquiry under the statute is at an end. In such a case, the fact that the shares were acquired as a gift, or for market value does not assist with the inquiry.
27. Accordingly, so the argument went, in the circumstances of this case, namely, that the Vercot shares were effectively a gift many years before the subject dividends were paid, and the other circumstances surrounding the payment of the dividends, the necessary answer to the inquiry required by s 273(2) is that there was no undue diversion of income in any of the relevant years of income. That is, on the facts of this case, the circumstances of the acquisition of the shares in 1995 did not affect in any way the arm's length derivation of the dividends in any of the relevant years of income.
28. The argument conceded that, in other circumstances, a disparity between the cost of the shares and their 'value' might indicate an undue diversion of the subsequent dividends. A dividend stripping scheme where the shares are acquired for an excessive amount which is then reimbursed by a dividend was given as an example par excellence. And where shares are acquired at an undervalue that may assist with an inference, given other factual circumstances such as common control of the company and the fund, that there had been an undue diversion of income. That is the factual context in which the Board cases relied on by the Commissioner sit. Those cases do not assist this Court with relevant issues of law.
Analysis and conclusion
29. There are, in our view, errors in the Commissioner's process of reasoning as disclosed by his Reasons for Decision (see  -  above). They include the following:
- (1) That under para (c), he is entitled to have regard, not only to the rate of dividend, but to the rate of return on the investment, what is otherwise called the "yield". We cannot see any mandate for this, particularly as the paragraph refers to the "rate of the dividend paid" not the "rate of return received" or "yield". But it is not, in our opinion, an error of consequence because there is no doubt that the Commissioner can have regard to the rate of return on the investment under para (f). It is undoubtedly a relevant matter to be taken into account as to whether or not the discretion is exercised.
- (2) His observation at  above in relation to para (f), in particular the words: "If the fund were dealing at arm's length with Vercot, the fund would have paid market value for the shares it acquired", is predicated on facts which are clearly erroneous. The trustee of the Fund did not acquire the four shares in Vercot by way of allotment from Vercot, but by way of transfer from an existing shareholder in Vercot; Vercot was not a party to the transaction; as such, the trustee of the Fund could hardly be said to be not dealing with Vercot at arm's length in relation to the transaction of acquisition. But again, we do not see this as an error of consequence because there is no dispute that the trustee of the Fund and the transferor of the shares were not dealing at arm's length with each other in relation to the Fund's acquisition of the shares, and that is a matter to which the Commissioner is entitled to have regard under para (f). Again, it is undoubtedly a relevant mater to be taken into account as to whether or not the discretion is exercised.
30. There are also, in our view, errors in the Tribunal's process of reasoning in reviewing the Commissioner's objection decision as disclosed in the Tribunal's Reasons (see  above). They include the following:
- (1) The Tribunal's conclusion that the reference to "value" in para (a) was, for historical reasons, a reference to "paid up value or par" not market value. We cannot agree. Historical considerations of the kind referred to by the Tribunal do not persuade us that the word "value" used in para (a), and in juxtaposition to the word "cost" in para (b), means anything other than market value. In short, the context dictates that result. But such an error is of no consequence because as the Tribunal itself recognised, the Commissioner was entitled to take the market value of the Vercot shares at the time of their acquisition into account under the heads of either paras (b) or (f), or in combination with each other.
- (2) The Tribunal's conclusion as to para (c), namely, as entitling the Commissioner to take into account the rate of return, as well as the rate of dividend, exemplifies the same error as that identified on the part of the Commissioner in [29(1)] above, but for the same reasons there referred to, it is an error without consequence.
31. The focus or thrust of the appellant's argument, namely, that if in the year of income the Fund derives dividends from a private company which represent distributions at a rate per share equal to the rate per share paid on all shares in the private company then, that is the end of the inquiry and the Commissioner cannot be concerned with other matters referred to in subs 273(2) and should or, to be more accurate, must, therefore, exercise his discretion not to treat the dividends as special income, is flawed on at least two bases. First, it is not supported by the text of subs 273(2). Second, its embrace would undermine the policy underlying subs 273(2), and its predecessors, of enabling the Commissioner to deny the concessional taxation of income where the income had been diverted from taxpayers not enjoying that concessional basis, through a non-arm's length acquisition of the shares, rather than through non-arm's length distributions by way of dividend.
32. As to the first, the text of subs 273(2) of the 1936 Act is clear. It does not support a limitation of the kind pressed by the appellant. None of the matters in paras (a) to (f) inclusive is given precedence over the others. To suggest that if one matter is to be answered favourably in support of the exercise of the discretion, consideration of the other matters is otiose, if not irrelevant, is not supported by the text of the legislation.
33. As to the second, the folly of the appellant's argument is even more apparent. It is clear, and the appellant seems to accept, that the policy underlying s 273, and its predecessors, is to enable the Commissioner to deny the concessional taxation of income which has been diverted from taxpayers not enjoying that status. On the other hand, the appellant seems to adopt the position that the only way in which this can occur, in the context of dividends paid on shares in a private company, is where differential dividend rates are paid on such shares so that dividends paid on shares held by the concessional taxpayer are greater than the dividends paid on shares held by non-concessional taxpayers. But that is not the only way such income diversion can occur, as the facts of the present case illustrate.
34. If the price at which the four shares in Vercot were sold to the Fund had been set at their market value, the price at which they were sold would not have secured the sale of even one share; the dividends on those four shares would have continued to accrue to the transferor, a non-concessional taxpayer. So understood, the income diversion has occurred by recourse to a non-arm's length transaction on the acquisition of the shares. The Commissioner, in our view, was entitled to have regard to that matter in declining to exercise his discretion not to treat the dividends as special income even where those dividends are paid rateably by reference to the number of shares held.
35. For these reasons, the Tribunal has not erred in affirming the Commissioner's objection decision not to exercise his discretion not to treat the dividends received from Vercot in the relevant years of income as special income.
36. The appeal must be dismissed with costs.