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Ruling

Subject:

Non-arm's length income of superannuation fund

Questions:

Will dividends to be paid to a superannuation fund (the Fund) by a private company (the Company) of which the Fund is a shareholder be considered to be non-arm's length income of the Fund under subsection 295-550(2) of the Income Tax Assessment Act 1997?

Answers:

No.

This ruling applies for the following period:

Income year ending 30 June 2013

The scheme commences in:

The second quarter of the income year ending 30 June 2013

Relevant facts and circumstances

The Applicant and another individual are the members and individual trustees of a regulated superannuation fund (the Fund).

A private company (the Company) has the following share structure:

Under the shareholders' agreement to be executed by all the shareholders (the Shareholders' Agreement), each of the shareholders must subscribe at par for the number of shares allotted to them. None of the shareholders holds a majority interest in the Company.

Each shareholder is represented on the Company's board of directors, the majority of whom are working directors. A non-working director will receive director's fees on a preset basis at market rate. A working director is a salaried employee of the Company and will receive a specified base annual salary, a specified annual car allowance and superannuation support from the Company based on the annual salary. The remuneration package of each working director is the same.

The Company will be managed on a day-to-day basis by the working directors who will report on and be responsible for the Company's activities and operations.

The directors of the Company (other than the Applicant) are not related to any member of the Fund, although they worked with the Applicant in another company before for an extensive period of time in various capacities.

The Company's capital requirement is based on the proposed price for acquiring an existing business (the Target Company), as well as working capital required to continue operating the business after the acquisition. The Target Company is an established entity and is being offered for sale through a business broker.

Under the Shareholders' Agreement, each shareholder must contribute its respective proportion of the Company's funding requirements, as is determined by the board from time to time. The shareholders must ensure that on the effective date (of the Shareholders' Agreement) they have advanced to the Company, in accordance with their respective proportions, a specified aggregate amount, and provide in aggregate at call a further amount as is required by the board of directors to sustain and grow the business.

The Company will not resort to any borrowing to finance the proposed acquisition of the Target Company.

In relation to the Fund's shareholding in the Company, an amount out of the assets of the Fund will be paid to the Company. This amount is more than 5% of the market value of the Fund's total assets. The trust deed by which the Fund was established empowers the trustee of the Fund to acquire shares and stocks.

To facilitate the Fund's injection of paid-up capital into the Company, the members of the Fund will make non-mandated contributions to the Fund as necessary.

None of the parties involved in the proposed acquisition of the Target Company has ever worked for the Target Company or is related by family or business to the owners of the Target Company.

Pursuant to the Shareholders' Agreement, business decisions in respect of matters not included in the business or quality management system plan must be made by unanimous consent of the board. This includes:

ð submission of tender, bid or proposal relating to any contract or commitment with a value that exceeds a specified amount;

ð execution of any contract or entering into any commitment with a value that exceeds a specified amount for each financial year;

ð incurring of any capital expenditure or liability that exceeds a specified amount;

ð obtaining new or increasing existing external borrowings;

ð entering into any transaction which is not proposed on an arm's length basis;

ð issue of any shares, or options to take up unissued shares, in the capital of the Company; and

ð execution of any service, employment or consultancy contract with a term that exceeds a specified period of time or a financial commitment that exceeds a specified amount.

In any board meeting each director will be entitled to one vote. In the event of a tie in voting, the vote of the chairman of the board will act as the deciding vote.

A working director no longer working actively within the business within the specified period of stay is required under the Shareholders' Agreement to sell all their shares equally to the other working directors in the first instance based on the formula for determining the value of the Company's shares stipulated in the Shareholders' Agreement.

Included in the Shareholders' Agreement is a 'Dividend Policy', which states that:

ð all working directors determine at a specified interval in a duly constituted board meeting whether to pay dividends. To pay dividends all four directors need to agree.

ð Dividend Access where such arrangements are approved by the Australian Taxation Office are distributed in proportion to shareholders and with full agreement of the board.

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(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)(f).

Reasons for decision

Summary

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

Detailed Reasoning

Whether dividends will be non-arm's length income (Question 1)

Income of a complying superannuation fund

Subdivision 295-H of the Income Tax Assessment Act 1997 (the ITAA 1997) deals specifically with the taxation of superannuation funds and other related entities. Under that Subdivision the taxable income of a complying superannuation fund consists of two components:

ð a non-arm's length component; and

ð a low tax component.

The non-arm's length component is taxed at 45%, and the low tax component is taxed concessionally at 15%, as per subsection 26(1) of the Income Tax Rates Act 1986.

Pursuant to subsection 295-550(2) of the ITAA 1997, an amount of dividend paid to the fund by a private company, or an amount of ordinary or statutory income that is reasonably attributable to such a dividend, is non-arm's length income of the fund per se unless the amount is consistent with an arm's length dealing.

Taxation Ruling TR 2006/7 (TR 2006/7) explains what amounts are considered to be 'special income' under section 273 of the Income Tax Assessment Act 1936. Though section 273 was repealed in 2007 and re-written as section 295-550 of the ITAA 1997, and the term "special income" has since been substituted by 'non-arm's length income', TR 2006/7 continues to have effect because the Explanatory Memorandum to the Tax Laws Amendment (Simplified Superannuation) Bill 2006 states, in paragraph 3.1, that:

…The rewritten provisions in Division 295 of the ITAA 1997 do not change the law as it currently operates under Part IX of the ITAA 1936.

On the question of whether parties are dealing with each other at arm's length or otherwise, it was stated in paragraphs 76 to 78 of TR 2006/7 that:

76. The Commissioner considers that parties are dealing with each other at arm's length in relation to a transaction if the independent minds and wills of the parties are applied to the transaction and their dealing is a matter of real bargaining. If this is not the case, the Commissioner will consider that the parties are not dealing with each at arm's length in relation to the transaction.

77. If the relationship of the parties is such that one party has the ability to influence or control the other, this will suggest that the parties may not be dealing at arm's length, but it will not be determinative.

78. Parties that are not at arm's length can deal with each other at arm's length in relation to a transaction and parties that are at arm's length can deal with each other in a way that is not at arm's length. An amount of income can only be special income under subsection 273(4) if, in relation to the particular transaction, the parties are not dealing with each other at arm's length.

The term 'arm's length' is not defined. However, subsection 995-1(1) of the ITAA 1997 states that:

In determining whether parties deal at arm's length, consider any connection between them and any other relevant circumstance.

This view is based on the decisions in Re Hains (deceased), Barnsdall v. Federal Commissioner of Taxation; Trustee of the Estate of the late AW Furse No 5 Will Trust v. Federal Commissioner of Taxation; and Granby Pty Ltd v. Commissioner of Taxation and the examples in the Explanatory Memorandum to the Superannuation Legislation Amendment Bill (No. 2) 1999, which, as enacted, inserted subsections 273(6) to (8) of the ITAA 1936.

These cases were also relied upon in Allen (As Trustee of the Allen's Asphalt Staff Superannuation Fund) v. Federal Commissioner of Taxation, where Justice Collier said:

…if conduct of parties is not consistent with conduct of independent third parties, because one party is exerting personal influence or control over the other or others, dealings between them cannot be termed 'arm's length'.

Subsection 295-550(3) of the ITAA 1997 requires 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 issue; and

(f) any other relevant matters.

The Company is a newly established company and has so far not:

(1) declared any dividend;

(2) paid any dividend on other shares in the Company; or

(3) applied any of its retained earnings to either pay up any amount unpaid on shares held by the Fund or pay in full for any unissued shares to be issued to the Fund.

To decide whether or not dividends to be derived by the Fund from the Company will be on an arm's length basis, the Commissioner will, therefore, have regard to those paragraphs in subsection 295-550(3) of the ITAA 1997 that are relevant at this point in time only. Those paragraphs are (a), (b) and (f). The Commissioner will consider the facts of the case in relation to those paragraphs as a whole.

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

The value and cost of the shares acquired

Pursuant to the Shareholders' Agreement, each shareholder of the Company must:

(1) subscribe at par for the ordinary shares allotted; and

(2) contribute to the Company its respective proportion of the Company's funding requirement as is determined by the board of directors from time to time, in particular a specified amount in aggregate upfront and a further specified amount in aggregate at call.

As the Company has not yet acquired the business of the Target Company, at this point in time its fully paid-up capital is its net worth. As each shareholder subscribes for ordinary shares at par, both the value and the cost of the Fund's shares in the Company are the same and are reflected by:

ð the number of ordinary shares held x the par value per share.

Since the Fund is paying the same subscription price as all other shareholders and is receiving the same value for the ordinary shares it subscribes for, the Commissioner considers that in so far as paragraphs 295-550(3)(a) and (b) of the ITAA 1997 are concerned, both the value and the cost of the Fund's shares are consistent with an arm's length dealing.

Other relevant 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)(f) of the ITAA 1997 requires regard to be given to any other relevant matters.

Apart from being advised that the managing director and the directors of the Company (other than the Applicant) are not related to any member of the Fund or to the owners of the Target Company, the Commissioner has also noted that:

1. the managing director, not being a working director, will receive director's fees on a preset basis at market rate;

2. the remuneration for each of the working directors as an employee of the Company is the same;

3. business decisions in respect of matters specified in the Shareholders' Agreement must be made by unanimous consent of the board;

4. in any board meeting each director will have one vote;

5. the agreed price for acquiring the Target Company is by negotiation through a business broker;

6. the value of any ordinary shares to be sold by a shareholder to another shareholder will be based on the formula stipulated in the Shareholders' Agreement;

7. whether to pay dividend will be determined by all the working directors at a duly constituted board meeting; and

8. dividends, if payable, will be paid in proportion to the shareholders with full agreement of the board.

The Commissioner is satisfied that none of the points noted above is inconsistent with an arm's length dealing.

On the basis of the facts advised by the Applicant and having regard to the matters listed in paragraphs 295-550(3)(a), (b) and (f) of the ITAA 1997, the Commissioner is of the opinion that 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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