Edited version of private ruling

Authorisation Number: 1011539470740

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Ruling

Subject: Non-arm's length income

Are dividends received by a self managed superannuation fund (the SMSF) from a private company (company B) “non-arm’s length income” under section 295-550 of the Income Tax Assessment Act 1997 (ITAA 1997) for the 2007-08 financial year?

No.

This ruling applies for the following period

1 July 2007 to 30 June 2008

The scheme commenced on

1 July 2007

Relevant facts

A private company (company A) operated a business. X and Y were company A’s two shareholders and directors.

Company A sold its business with the final sale proceeds being received around six months later.

Company A changed its name to company B.

The SMSF is a complying self managed superannuation fund. X and Y mentioned above are the two members and trustees.

The SMSF is the sole shareholder of company B after acquiring the shares from X and Y. This acquisition by the SMSF was permitted by the application of section 71 of the Superannuation Industry (Supervision) Act 1993 and regulation 13.22C of the Superannuation Industry (Supervision) Regulations 1994. An approved auditor report showing no contraventions by the SMSF was provided for the year ended 30 June 2006.

The SMSF’s accounts for the year ended 30 June 2006 indicate the superannuation fund acquired and accounted for the shares at market value.

At 30 June 2007 company B’s only assets were cash investments.

The directors decided to wind up company B and distribute its assets to the sole shareholder.

Company B paid dividends to the SMSF.

The payment of the dividends reduced company B’s assets to nil (that is, all assets were distributed to the shareholder)

Company B was officially deregistered.

Relevant legislative provisions

Income Tax Assessment Act 1936 Section 273.

Income Tax Assessment Act 1997 Section 295-545.

Income Tax Assessment Act 1997 Section 295-550.

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

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

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

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

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

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

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

Reasons for decision

Summary

After considering the matters listed in paragraphs 295-550(3)(a) to (f) of the ITAA 1997, the Commissioner is of the opinion the dividends paid by the company B to the SMSF are not “non-arm’s length income” as defined in subsection 295-550(2) of the ITAA 1997.

Detailed reasoning

From 1 July 2007, the income of a complying superannuation fund is split into a non-arm’s length component and a low tax component, in accordance with section 295-545 of the ITAA 1997.

It should be noted that the concept of non-arm's length component in the ITAA 1997 replaced the special income component in section 273 of the Income Tax Assessment Act 1936 (ITAA 1936).

The non-arm’s length component for an income year comprises non-arm’s length dividends received from private companies, non-fixed interest trust distributions, and any income derived from transactions where the parties are not dealing with each other at arm’s length. This component is reduced by any deductions attributable to that income and is then taxed at the highest marginal rate. Derived in this context is applicable to both ordinary and statutory income.

The remaining part of the entity’s taxable income for the income year is the low tax component which is taxed at a concessional rate (currently 15 per cent).

It should be noted, that the exemption from tax, for the income from assets of a complying superannuation fund set aside to meet current pension liabilities, does not apply to non-arm’s length income in accordance with paragraphs 295-385(2)(a) and 295-390(2)(a) of the ITAA 1997.

Non-arm’s length income

Section 295-550 of the ITAA 1997 states that:

295-550(1) An amount of ordinary income or statutory income is non-arm's length income of a complying superannuation fund, a complying approved deposit fund or a pooled superannuation trust (other than an amount to which subsection (2) applies or an amount derived by the entity in the capacity of beneficiary of a trust) if:

(a) it is derived from a scheme the parties to which were not dealing with each other at arm's length in relation to the scheme; and

(b) that amount 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.

295-550(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.

295-550(3) In deciding whether an amount is consistent with an arm’s length dealing under subsection (2), have regard to:

the value of shares in the company that are assets of the entity; and

the cost to the entity of the shares on which the dividend was paid; and

the rate of that dividend; and

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

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

any other relevant matters.

In this case, the SMSF has received dividends from a private company, company B. As such, paragraph 295-550(2)(a) applies to any dividends received.

In applying subsection 295-550(2) of the ITAA 1997 to the facts of this case, the Commissioner will consider paragraphs 295-550(3)(a) to (e) of the ITAA 1997 that indicate whether or not the dividends are derived on an arm’s length basis. The Commissioner will consider a matter to be relevant under paragraph 295-550(3)(f) of the ITAA 1997 if it indicates whether or not the dividends are derived on an arm’s length basis. The facts of the case and all the matters contained in paragraphs 295-550(3)(a) to (f) of the ITAA 1997 cannot be considered in isolation to each other but must be considered as a whole.

The Commissioner has issued Taxation Ruling TR 2006/7, titled 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).

TR 2006/7 refers to former section 273 of the ITAA 1936 which concerned special income. In this regard, TR 2006/7 specifically discusses the matters contained in former paragraphs 273(2)(a) to (f) of the ITAA 1936, which were rewritten as paragraphs 295-550(3)(a) to (f) of the ITAA 1997. Accordingly, TR 2006/7 provides useful guidance on the matters to be considered in the interpretation of section 295-550 of the ITAA 1997.

Paragraph 19 of TR 2006/7 states:

Dividends are only derived on an arm's length basis when the shares are acquired, the investment is maintained, and the dividends are paid on an arm's length basis. If the shares are acquired at market value, the private company is not involved in non-arm's length dealings and the rate of dividend is the same as the rate of dividend paid on other shares in the company or is reasonable having regard to investment risk, and there are no other matters that the Commissioner will consider relevant, the Commissioner will form the opinion that it would be reasonable not to treat the dividend as special income.

With this statement in mind, it is proposed to deal with paragraphs 295-550(a) to (f) in turn.

Paragraphs 295-550(3)(a) and (b):

These paragraphs consider the value of the shares and the cost of the shares. Company B’s only asset was cash in the form of bank and term deposits. This being the case, the true value or market value of the company is the total of those cash deposits. As there were only two issued shares in the company, the value of each share is 50% of the total assets. The financial records of both company B and the SMSF (including the member accounts) show the shares in the company B were acquired and accounted for at market value.

It is considered these circumstances would not support a finding of “non-arm’s length income”.

Paragraphs 295-550(3)(c) and (d):

These paragraphs deal with the rate of the dividend paid by the company to the superannuation fund and whether the company has paid a dividend (and at what rate) on other shares held in the company. They are designed to highlight dealings with dividends that are more favourable to shareholders that are ‘related’ to the company when compared to the dividends paid to ‘un-related’ shareholders of the company.

There were only two shares in the company B, both held by the one shareholder, the SMSF. The directors had decided to wind up the company. To return the company’s assets to the shareholders to affect the wind up meant the whole of the assets had to be paid as dividends. In effect, the total of the three dividends paid form the final dividend or distribution of the company’s worth. Accordingly, these circumstances would not support a finding of “non-arm’s length income”.

Paragraph 295-550(3)(e):

This paragraph deals with whether the company had issued any shares in the company to the superannuation fund in satisfaction of a dividend paid by the company. In this case there were no shares issued by the company B in satisfaction of dividends so it is of no relevance in this case.

Paragraph 295-550(3)(f):

Although the private company and superannuation fund are clearly not at arms length, the dealings in relation to the payment of dividends have been consistent with an arm's length deal which under the second limb of subsection 295-550(2), allows the dividends to be treated as statutory income (that is, not “non-arm’s length income”)

Conclusion:

After considering the matters listed in paragraphs 295-550(3)(a) to (f) of the ITAA 1997, the Commissioner is of the opinion the dividends paid by company B to the SMSF are not “non-arm’s length income” as defined in subsection 295-550(2) of the ITAA 1997.

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