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Ruling

Subject: Non-arm's length income

Reasons for decision

Question 1

Will income derived by the self managed superannuation fund (the Fund) indirectly through a unit trust (the Trust) being a dividend in a related private company (Private Company) be treated as non-arm's length income of the Fund for the purposes of section 295-550 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

This ruling applies for the following period:

Year ending 30 June 2013

The scheme commenced on:

During the income year ending 30 June 2013

Relevant facts and circumstances

The Fund

The Fund is a complying single member self managed superannuation fund.

The Fund has a corporate trustee (the Trustee).

The only member of the Fund (the Member) is a director of the Trustee.

The Fund owns all the units in the Trust which were acquired over a period of time for less than $5.00 per Unit.

Later, the Trustee of the Trust redeemed a large number of units in consideration of the sum equal to the original purchase price of one unit.

The Trust

The trustee of the Trust is X.

The Member of the Fund is a director of X.

The units in the Trust comprise of Capital Units and Income Units.

Recently, the Trust's trust deed (the Deed) was amended to, among other things, remove any power or discretion on the part of the trustee to retain or capitalise distributable income of the Trust.

The Deed, as amended, relevantly provides that:

· The Trustee may create and issue additional Capital Units from time to time for fair value, or for fair value transferred from reserves.

· The Trustee may create and issue additional Income Units for nominal value of $1 per Unit or as the Trustee shall otherwise decide.

· The Trustee may at any time at its absolute discretion establish general and other reserves as part of the Trust Fund and without regard to the beneficial interest held by any Unit Holder issue to any Unit Holder (whether Capital or Income) new Capital Units against the amount credited to such reserves.

The question as to whether any amount is received on income or capital account or form part of the income or capital of the Trust Fund shall be determined by the Trustee at its absolute discretion.

Each Income Unit shall entitle the Income Unit Holder to a contingent entitlement in the Income of Trust Fund but subject to Parts 8 and 9 of the Deed shall not entitle the Income Unit Holder to any particular interest in the Trust Fund or any part thereof or the Income of the Trust Fund.

The holder of a Capital Unit shall not be entitled to a share in the Net Income of the Trust Fund except to the extent that the Trustee declares in terms of Part 8 of the Deed.

The Trustee may, after paying the whole or any part of any Net Capital Profit of the Trust Fund, credit any amount remaining (less any tax payable) to capital reserves.

The Trustee may create and issue different classes of Capital Units and may designate classes of Capital Units in such manner as it deems appropriate to identify such classes.

The Trustee may redeem Units at fair value for cash or other consideration.

In addition to powers conferred upon trustees by law, the Trustee has absolute discretion to deal with the Trust Fund and its assets and liabilities, and to act on behalf of the Trust in any manner upon such terms and conditions as the Trustee shall think fit.

The income of the Trust is to be appointed each year to the Fund.

The Private Company

The Private Company issued to the trustee of the Trust, a number of ordinary shares for a total sum equal to less than $5.00 per share.

The Private Company intends to declare/pay dividends to the trustee of the Trust in respect of the shares which, per share, is equal to more than 400 times the original purchase price of one ordinary share.

Relevant legislative provisions

Income Tax Assessment Act 1936 Subsection 272-5(1) in Schedule 2F

Income Tax Assessment Act 1936 Subsection 272-5(2) in Schedule 2F

Income Tax Assessment Act 1936 Section 272-5

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

Income Tax Assessment Act 1997 Section 295-550.

Income Tax Assessment Act 1997 Subsection 295-550(4)

Income Tax Assessment Act 1997 Subsection 295-550(5)

Income Tax Assessment Act 1997 Subsection 995-1(1)

Taxation Administration Act 1953 Division 359 of Schedule 1

Superannuation Industry (Supervision) Act 1993 Section 71A

Reasons for decision

Meaning of special income

In accordance with subsection 295-545(1) of the ITAA 1997, the income of a complying superannuation fund, complying approved deposit fund or pooled superannuation trust is split into a non-arm's length component and a low tax component.

Section 295-550 of the ITAA 1997 lists the amounts of ordinary income or statutory income that are non-arm's length income of entities listed above and, as far as relevant, states:

,,,

(4) Income *derived by the entity as a beneficiary of a trust, other than because of holding a fixed entitlement to the income, is non-arm's length income of the entity.

(5) Other income *derived by the entity as a beneficiary of a trust through holding a fixed entitlement to the income of the trust is non-arm's length income of the entity if:

(a) the entity acquired the entitlement under a *scheme, or the income was derived under a scheme, the parties to which were not dealing with each other at *arm's length; and

(b) 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.

Thus, to determine whether an amount is non-arm's length income of the Fund, there are two issues to consider, namely:

(a) whether the Fund holds a fixed entitlement to the income of the Trust; and

(b) if the Fund does hold a fixed entitlement to the income of the Trust, whether the amount derived by the Fund is otherwise special income in accordance with subsection 295-550(5) of the ITAA 1997.

Meaning of 'fixed entitlement'

In accordance with subsection 995-1(1) of the ITAA 1997, an entity has a fixed entitlement to a share of the income or capital of a company, partnership or trust if the entity has a fixed entitlement to that share within the meaning of Division 272 in Schedule 2F to the Income Tax Assessment Act 1936 (ITAA 1936).

Subsection 272-5(1) in Schedule 2F of the ITAA 1936 states:

If, under a trust instrument, a beneficiary has a vested and indefeasible interest in a share of income of the trust that the trust derives from time to time, or of the capital of the trust, the beneficiary has a fixed entitlement to that share of the income or capital.

Further, subsection 272-5(2) in Schedule 2F of the ITAA 1936 provides that if:

(a) a person holds units in a unit trust; and

(b) the units are redeemable or further units are able to be issued; and

(c) if units in the unit trust are listed for quotation in the official list of an approved stock exchange - the units held by the person will be redeemed, or any further units will be issued, for the price at which other units of the same kind in the unit trust are offered for sale on the approved stock exchange at the time of the redemption or issue; and

(d) if the units are not listed as mentioned in paragraph (c) - the units held by the person will be redeemed, or any further units will be issued, for a price determined on the basis of the net asset value, according to Australian accounting principles, of the unit trust at the time of the redemption or issue;

then the mere fact that the units are redeemable, or that the further units are able to be issued, does not mean that the person's interest, as a unit holder, in the income or capital of the unit trust is defeasible.

Meaning of 'vested and indefeasible'

The terms 'vested and indefeasible' are not defined in the ITAA 1997. Therefore, the meaning to be given to these terms must be determined according to the ordinary meaning of the words having regard to the context in which they appear.

In Dwight v. Commissioner of Taxation (Dwight) Justice Hill of the Federal Court made the following comments concerning the meaning of the terms 'vested and indefeasible':

The words "vested" and "indefeasible" in the context of trust law are technical legal words of limitation, which have a well understood meaning to property conveyancers. Estates may be vested in interest or vested in possession, the difference being between a present fixed right of future enjoyment where the estate is said to be vested in interest and a present right of present enjoyment of the right, where the estate is said to be vested in possession: Glenn v Federal Comr of Land Tax (1915) 20 CLR 490 at 496 per Griffith CJ at 501 per Isaacs J

An interest is said to be defeasible where it can be brought to an end and indefeasible where it can not. Thus, a beneficiary with an interest which is not contingent but which interest may be brought to an end by the exercise of a power of appointment, would be said to have a vested but defeasible interest: cf Queensland Trustees Ltd v Comr of Stamp Duties (1952) 88 CLR 54 at 63, and Re Kilpatrick's Policies Trusts [1966] Ch 730.

In Walsh Bay Developments Pty Ltd v. Federal Commissioner of Taxation, Justices Beaumont and Sackville of the Federal Court referred to the distinction between vested but defeasible interests and an indefeasible interest as stated in Cheshire's Modern Law of Real Property, where the author said:

An defeasible interest is an interest that is to be defeated by the operation of a subsequent or mixed condition.

An indefeasible interest, or an absolute interest as opposed to a defeasible interest, is one that is not subject to any condition.

The Explanatory Memorandum to the Taxation Laws Amendment (Trust Loss and Other Deductions) Act 1998, which accompanied the enactment of former section 272-5 of the ITAA 1936 states:

13.4 A person has a vested interest in something if the person has a present right relating to the thing. Stated simply, a vested interest is one that is bound to take effect in possession at some point in time. A vested interest is to be contrasted with a 'contingent' interest which may never fall into possession. If an interest of a beneficiary in income or capital is the subject of a condition precedent, so that an event must occur before the interest becomes vested, the beneficiary does not have a vested interest to the income or capital since such an interest is instead 'contingent' upon the event occurring.

13.5 In traditional legal analysis, a person can be said to be either 'vested in possession' or 'vested in interest'. A present interest, i.e. one that is being enjoyed, is said to be 'vested in possession'; a future interest, i.e. one which gives its holder a present right to future enjoyment, is said to be 'vested in interest'. A person is vested in possession where the person has a right to immediate possession or enjoyment of the thing in question. In the definition of fixed entitlement, 'vested' includes both vested in possession and vested in interest.

13.6 Because vested interests include future interests, a person can have a vested interest in a thing even though the person's actual possession and enjoyment of the thing is delayed until some time in the future.

13.7 A vested interest is indefeasible where, in effect, it is not able to be lost. A vested interest is defeasible where it is subject to a condition subsequent that may lead to the entitlement being divested. A condition subsequent is an event that could occur after the interest is vested that would result in the entitlement being defeated, for example, on the occurrence of an event or the exercise of a power. For example, where a beneficiary's vested interest is able to be taken away by the exercise of a power by the trustee or any other person, the interest will not be a fixed entitlement.

13.8 Where the trustee exercises a power to accumulate income or capital of the trust in accordance with the trust deed, the accumulation does not result in a beneficiary's interest being taken away or defeased as long as the beneficiary nevertheless remains entitled at some future time to enjoy his or her share of the income or capital which has been accumulated.

13.11 Subsection 272-5(2) is not intended to disturb the ordinary meaning of 'vested and indefeasible interest' in any way except in accordance with its terms. Thus, if an interest is vested and indefeasible ignoring subsection 272-5(2), it will be a fixed entitlement.

It is an essential element of subsection 272-5(1) in Schedule 2F to the ITAA 1936 that in order to have a fixed entitlement to a share of income or capital there must be a vested or indefeasible interest 'under a trust instrument'. In all cases, the determining factor in deciding if fixed entitlements exist will be the terms of the trust instrument under which the trust is constituted.

Therefore, the first step in determining whether a beneficiary has a vested and indefeasible interest in a share of the income or capital of a trust is to ascertain the terms of the trust upon which the relevant trust property is held. As the Full High Court stated in CPT Custodians Pty Ltd v. Commissioner of State Revenue (Vic); Commissioner of State Revenue (Vic) v. Karingal 2 Holdings Pty Ltd, in taking this step:

'…a priori assumptions as to the nature of unit trusts under the general law and principles of equity [will] not assist and would be apt to mislead. All depends, as Tamberlin and Hely JJ put it in Kent v SS "Maria Luisa" (No 2), upon the terms of the particular trust. The term "unit trust" is the subject of much exegesis by commentators. However, "unit trust", like "discretionary trust", in the absence of an applicable statutory definition, does not have a constant, fixed normative meaning which dictate the application to particular facts of the [relevant statutory definition]…'

Determining whether a beneficiary has a 'vested and indefeasible' interest in a trust, requires an extensive review of the relevant trust instrument including individual clauses to determine, based on the principles established in the case law, the existence of defeasible powers. After considering the terms of the Deed, it is our view that the Fund does not hold a fixed entitlement to a share of income or capital of the Trust. This view is based on the following factors (defeasible powers):

· Income Unit Holders are entitled to a distribution of the net income of the trust, and the Capital Unit Holders are entitled to a distribution of the capital profits of the trust. What amounts are received on income account and what amounts are received on capital account is to be determined by the trustee at its absolute discretion in accordance with the relevant clause of the Deed.

· The separation of units into income and capital units in itself does not affect a fixed entitlement because it does not involve discretion for the trustee, however, the absolute discretion given to the trustee under the Deed to determine what amounts form income or capital provide the trustee with the power to stream income or capital to favour one class of unit holders at the detriment of the other class of unit holders.

· A clause of the Deed grants the trustee absolute discretion as to how the assets of the trust are invested or otherwise dealt with, and thus may directly influence what proportion of the trust's return on investments represents net income or capital profits. This enables the trustee to conduct capital skewed investments where the interests of the income unit holders may be undermined in favour of the capital unit holders.

· The Trustee may create and issue additional Income Units for a nominal value or as the Trustee shall otherwise decide. If the trustee has a power to issue new units or to cancel or vary existing units, particularly if those powers can be exercised for something other than an arm's length consideration, then it cannot be asserted that the beneficiary had an interest in the income when it was earned that was bound to take effect in possession at some time.

· A clause of the Deed provides that the Trustee may redeem Units at fair value for cash or other consideration rather than for a price determined on the basis of the net asset value (according to Australian accounting principles) of the unit trust at the time of the redemption. Information provided indicates that the units in the Trust were acquired over a number of years for $1.00 per unit, yet a few years later the trustee redeemed thousands of units for the total sum of $1.00.

· A clause of the Deed states that each Income Unit shall entitle the Income Unit Holder to a contingent entitlement in the Income of Trust Fund but subject to Parts 8 and 9 of the Deed shall not entitle the Income Unit Holder to any particular interest in the Trust Fund or any part thereof or the Income of the Trust Fund.

· In accordance with the relevant clause of the Deed, the holder of a Capital Unit is not entitled to a share in the Net Income of the Trust Fund except to the extent that the Trustee declares in terms of Part 8 of the Deed.

· In accordance with the relevant clause of the Deed, the Trustee may at any time at its absolute discretion establish general and other reserves as part of the Trust Fund and without regard to the beneficial interest held by any Unit Holder issue to any Unit Holder (whether Capital or Income) new Capital Units against the amount credited to such reserves (Clause 3.1(h)).

· The Trustee may, after paying the whole or any part of any Net Capital Profit of the Trust Fund, credit any amount remaining (less any tax payable) to capital reserves.

Application of subsection 295-550(4) of the ITAA 1997

As the Fund will not derive income as a beneficiary of a trust holding a fixed entitlement to the income, it is not necessary to consider the application of subsection 295-550(4) of the ITAA 1997.

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