Edited version of private ruling

Authorisation Number: 1011597483163

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Ruling

Subject: Non arm's length income

Question

Will dividends to be paid to a self managed superannuation fund (the Fund) from a private company (the Company) be non-arm's length income, in accordance with subsection 295-550(3) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

This ruling applies for the following period:

1 July 2009 to 30 June 2012

The scheme commences on:

1 July 2009

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

The trustee of the Fund is contemplating acquiring shares in the Company on behalf of the Fund.

The Company was incorporated in 2008.

The Fund and its Members

The Fund is a complying self managed superannuation Fund established by trust deed over five years ago.

The Fund has two Members, who are also the trustees of the Fund.

Proposed acquisition of shares

The Fund decided to invest in the Company as a result of the managing entity (ME) having initially approached a Member of the Fund (the Fund Member) to become a user of a facility (the facility). The facility is to be operated by the Company.

According to the Shareholders' Agreement (the Agreement), an entity associated with a user may acquire shares in the Company. The user then becomes the shareholder's designated person that may use the facility.

As the Fund Member agrees to become a user, the ME will invite the Fund to be a shareholder of the Company. In this context, the Fund will be a shareholder of the Company, and the Fund Member a designated person.

Consequently, the Fund Member, as well as their employees, agents and contractors, may, under the Agreement, use the facilities allocated to the shareholder.

Under the Agreement, the number of shares to be allotted to, and the subscription price payable by, a shareholder will be determined by reference to the usage of the facility by the shareholder, the type of service to be performed in the facility and the estimated costs of establishing the facility.

The ME as founder and manager of the facility, is entitled to subscribe for over 20% of the Company's total shares at the same price per share as is payable by a shareholder and for an additional parcel of shares for which no subscription price is payable. Consequently, the ME will, in total, hold over 25% of the Company's shares while all other shareholders (the Fund included) will hold the remaining shares.

The acquisition of shares in the Company by the Fund will not cause the Fund at any time to breach the Superannuation Industry (Supervision) Act 1993.

The individual trustees and Members of the Fund have no relationship with the directors or shareholders of the Company, other than the Fund Member using the facility as a designated person. Neither will they be employed by the Company.

The individual trustees and Members of the Fund have no relationship, business or personal, with the directors or shareholders of the ME (apart from the Fund's shareholding in the Company).

The Company and other entities

The land on which the premises are situated is owned by an unrelated party and is leased to an organisation (the Organisation) on commercial terms. The Company, managed by the ME, will operate the facility on newly constructed premises subleased from the Organisation on commercial terms. The individual trustees and Members of the Fund have no relationship with the owner of the land.

The Organisation was incorporated over five years ago. The Fund Member, as Director of the Organisation, is a Member of both the board of trustees and board of directors.

The Fund Member has not been nominated as a director of the Company and will not accept nomination for reasons of independency of roles.

The Fund Member intends to lease premises in the newly constructed facility, subleased from the Organisation.

The Fund Member will conduct some of their business from the facility but the majority of services will continue to be conducted at another location.

Shareholding

Shares intended to be allocated to the Fund will be less than 10% of the total shares issued. The Fund's shareholding will confer upon its owner the same rights, privileges and conditions as other shareholders who use the facility.

The subscription price is based on the Company's share capital requirements relative to borrowing capacity and is the same for all shares.

Revenue, Costs, Profits and Losses

According to the Agreement:

1. the Company will retain all revenue derived from the operation of the facility, with fees for services performed in the facility by any user being retained by the user;

2. the profits or losses of the Company will be allocated between the shareholders as follows:

a) the holder of each share will share proportionately the majority of all the profits derived from, or all the losses incurred by, the Company

b) the remaining profits or losses of the Company will be pooled, and the holder of each share will be entitled to, or be responsible for, their proportionate share of the pooled amount

c) the holder of each share will be entitled to their proportionate share of any profits derived from usage of the facility by non-shareholders or be responsible for their proportionate share of any losses arising from such usage;

3. in its balance sheet the Company will maintain separate retained-earnings accounts for each shareholder for the purposes of calculating the amounts of dividend payable to each shareholder pursuant to the Agreement.

The Company's revenue will be derived from both usage of the facility and its other business activities. The Company makes a profit if its revenue exceeds its costs, and vice versa.

Dividend Policy

The board of the Company is required by the Agreement to adopt a policy of declaring dividends only after having exercised prudent financial management and taken into account the business plan, working capital requirements, banking covenants and other operational requirements of the Company. It is intended that dividends will be declared and paid once a year. The dividend payable to each shareholder will be calculated in accordance with the Agreement.

The Company's dividend policy is based on the ME's past policy and experience with management of similar facilities.

There are currently no minutes relating to the Company's dividend policy. No financial accounts are yet available as the facility is currently in the course of fit-out and is not yet commissioned.

Relevant legislative provisions

Income Tax Assessment Act 1936 Subsection 273(2).

Income Tax Assessment Act 1997 Section 295-545.

Income Tax Assessment Act 1997 Section 295-550.

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

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

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).

Superannuation Industry (Supervision) Act 1993

Reasons for decision

Summary

The transactions involving the acquisition of the shares of the Company by the Fund and the future payment of the dividends by the Company will produce an arm's length outcome.

Therefore, the dividends that may be paid by the Company to the Fund will not be non-arm's length income of the Fund.

Detailed reasoning

In accordance with section 295-545 of the ITAA 1997, the taxable income of a complying superannuation Fund is split into a 'non-arm's length component' and a 'low tax component'.

Any income falling within the non-arm's length component is reduced by any deductions to the extent that the deductions are attributable to that income and is then taxed at the highest marginal rate (currently 45%).

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%).

The non-arm's length component, as defined in section 295-550 of the ITAA 1997, includes dividends paid to the Fund by a private Company unless the amount is consistent with an arm's length dealing.

The Commissioner has issued Taxation Ruling TR 2006/7 (TR 2006/7) which refers to the now repealed section 273 of the Income Tax Assessment Act 1936 (ITAA 1936), concerning 'special income'. As the wording of section 273 of the ITAA 1936 is similar to section 295-550 of the ITAA 1997, TR 2006/7 provides useful guidance on the factors to be considered in the interpretation of the current provision.

In applying subsection 295-550(3) of the ITAA 1997 to the facts of this case, the Commissioner will have regard to paragraphs 295-550(3)(a) to (f) of the ITAA 1997 in order to decide whether or not 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.

Subsection 295-550(3) states that:

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 issues, and

f. any other relevant matters.

It is proposed to deal with each of these matters in turn.

The entity in this case is the Fund, which is a complying self managed superannuation Fund.

The Company is a private Company that will operate a proposed facility.

In deciding whether any dividend payable to the Fund by the Company is consistent with an arm's length dealing, paragraphs 295-550(3)(a) and (b) of the ITAA 1997 requires regard to be given to:

· the value of shares in the Company that are assets of the Fund and

· the cost to the Fund of the shares on which any dividend was paid.

The applicant has advised that the subscription price is based on the Company's capital requirements relative to its borrowing capacity and is the same for all ordinary fully-paid shares. In other words, the Fund will be paying the same subscription price as other user shareholders.

The applicant has advised that fully paid shares of the Company to be held by the Fund, if the proposed share acquisition proceeds, will be less than 10% of the total issued shares of the Company.

Since the Fund will be paying the same subscription price as all other user shareholders, the cost of the share to the Fund will be on an arm's length basis and is, therefore, a neutral factor for the purposes of paragraph 295-550(3)(b).

It should be noted that, in recognition of the ME's contribution as founder and manager of the facility, the Agreement provides that no subscription price is payable by ME in respect of a small parcel of shares to be issued to the ME. Relative to other shareholders, it costs ME less to subscribe for its shares in the Company. Further, although acquired at no cost, this share parcel will nevertheless entitle the ME to dividends in accordance with the method of calculation stipulated in clause 7 of the Schedule.

However, it is considered that this disparity is not a negative factor in the Commissioner's consideration of paragraphs 295-550(3)(a) and (b) for the following reasons:

(a) the ME, the founder and manager of the facility, is not related to the Fund;

(b) the ME is dealing with the Fund in the same way as it is dealing with all other shareholders; and

(c) Insofar as usage of the facility by other shareholders are concerned, the ME will only be sharing, together with other shareholders, the pooled profits and losses that may arise from such usage.

As the facility is not yet operative, at this stage no profit or loss of the Company can be ascertained and, in turn, no market value of the shares or rate of dividend paid on the shares are available. It is, therefore, not possible to have a comparison between:

i. the market value and the cost of the shares, or

ii. the market value of the shares and the rate of dividend paid on the shares, or

iii. the cost of the shares and the rate of dividend paid on the shares

Accordingly it is considered that the value and the cost, of the Fund's shares in the Company (if acquired) are neutral factors for the purposes of deciding whether any dividend payable to the Fund by the Company is consistent with an arm's length dealing.

In deciding whether any dividend payable to the Fund by the Company is consistent with an arm's length dealing, paragraphs 295-550(3)(c) and (d) require regard to be given respectively to:

· the rate of dividend paid on the Fund's shares and

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

Pursuant to the Agreement, the amount of dividend payable to a user shareholder will depend on the extent to which the user shareholder has contributed towards the profits of, or otherwise been responsible for the losses of, the Company. This applies to all user shareholders, each of whom will thus be on equal footing in so far as calculation of profits and losses and determination of dividend payable are concerned. For the purposes of paragraph 295-550(3)(c), this is considered to be a neutral factor.

As noted before, at this stage no rate of dividend paid is available. Accordingly, it is considered that for the purpose of deciding whether any dividend payable to the Fund by the Company is consistent with an arm's length dealing, the rate of dividend for the Fund and that for the other shares are neutral factors.

In deciding whether any dividend payable to the Fund by the Company is consistent with an arm's length dealing, paragraph 295-550(3)(e) requires regard to be given to whether the Company has issued any shares to the Fund in satisfaction of a dividend paid by the Company (or part of it) and, if so, the circumstances of the issue.

As no dividend has yet been paid by the Company to the Fund, it is not necessary to consider if the Company has issued, and the circumstances for issuing, any shares to the Fund in satisfaction of a dividend paid in part or in whole.

Accordingly, it is considered that for the purpose of deciding whether any dividend payable to the Fund by the Company is consistent with an arm's length dealing, issue of shares in satisfaction of dividend is a neutral factor.

In deciding whether any dividend payable to the Fund by the Company is consistent with an arm's length dealing, paragraph 295-550(3)(f) requires regard to be given to any other relevant matters.

A matter which the Commissioner considers relevant and should therefore have regard to is the

manner in which profits or losses arising from the facility's operation will be shared by the shareholders of the Company, as this will determine the amount of dividend each shareholder of the Company will be paid.

As noted before, the profits or losses of the Company are based on the difference between the revenue of, and the costs to, the Company arising from usage of the facility and its other business activities. Any ascertained profits or losses are then allocated to each shareholder in accordance with the Agreement.

Pursuant to the Agreement, the Company's profits or losses to be allocated to a shareholder will consist of the shareholder's proportionate share (which is based on their usage of the facility) of:

a) the majority of all the profits derived or all the losses incurred by the Company

b) the Company's pooled profits or losses and

c) any profits or losses arising from usage of the facility by non-shareholders.

A source of the facility's revenue will come from fees charged for the use of the facility. However, such fees exclude any fee for services performed in the facility by any user. Effectively this will mean that a shareholder's share of any profits of the Company will be confined to those derived from usage of the facility by both participating and non-participating users and that, therefore, fees for users (participating users included) will not be channelled back by way of profit to shareholders who may be taxed at a lower rate than their respective participating users.

Furthermore, under this profit and loss sharing arrangement, generally a shareholder will share a greater amount of the Company's profit or loss if the shareholder uses the facility more. As the extent of usage is tied in with the shareholder's number of shares pursuant to the Agreement, it reflects the level of investment risk that the shareholder is prepared to take. As each shareholder holds a different number of shares, each shareholder takes a different level of investment risk.

According to paragraph 49 of TR 2006/7, if different dividend rates reflect different levels of investment risk, the comparative rates of dividends will be a favourable factor towards the dividend paid not being considered to be non-arm's length income.

Also, pursuant to the Agreement, the board of the Company must adopt a policy of declaring dividends only after having exercised prudent financial management and taken into account the business plan, working capital requirements, banking covenants and other operational requirements of the Company.

Accordingly it is considered that the manner in which profit or loss will be allocated, and any dividend will be paid, to the Fund is consistent with an arm's length dealing.

Another matter which the Commissioner considers relevant and should therefore have regard to is the shares for which no subscription price will be payable by the ME.

With the ME not being required to pay any subscription price for some of its shares, the value per share held by the Fund and other user shareholders will be diluted. Effectively the Fund and other shareholders will be paying a premium on each share to be acquired. When dividends becomes payable, all shares will, however, be eligible to dividends in accordance with the same method of calculation stipulated in the Agreement. In this regard, the ME may be looked upon as not acquiring shares on an arm's length basis.

On the other hand, regard has to be given to the fact that the ME is the founder and manager of the Company. It possesses the requisite expertise to set up and, eventually, run the facility. Other shareholders, who would like to join the venture utilising the ME's expertise, effectively agree to pay a premium for such expertise.

Furthermore, relative to this preferential treatment for the ME, the Fund is in the same position as all the other shareholders.

For these reasons it is considered that the availability of free shares for the ME is a neutral factor.

One further matter the Commissioner considers relevant and should therefore have regard to is the sub-leasing arrangement between the Company and the Organisation. The Company will operate the facility on newly constructed premises sub-leased from the Organisation This sub-leasing is on commercial terms, Also, The Fund Member, the current Director of the Organisation, is not and will not be a director of the Company. With or without the Organisation subsequently nominating a person to be a director of the Company pursuant to the Agreement, this sub-leasing arrangement given its commerciality does not put the Fund into either a more favourable or unfavourable position compared with other shareholders. On this basis, it is considered that this sub-leasing arrangement is a neutral factor.

Conclusion

On the whole and having regard to each of the matters listed in paragraphs 295-550(3)(a) to (f) of the ITAA 1997, the Commissioner is of the opinion that the transactions involving the acquisition of the shares of the Company by the Fund and future payment of the dividends by the Company to the Fund will produce an arm's length outcome.

Therefore, the dividends that may be paid by the Company to the Fund will not be non-arm's length income of the Fund.

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