Edited version of your written advice

Authorisation Number: 1012948356465

Date of advice: 29 January 2016

Ruling

Subject: Non-arm's length income of a superannuation fund

Questions and Answers

1. Will the distribution received by the Fund from the related Trust be non-arm's length income of the Fund under section 295-550 of the Income Tax Assessment Act 1997 (ITAA 1997)?

No

2. Will the Fund be entitled to a franking credit tax offset for the amount of the franking credits attached to distribution received from the related Trust?

Yes

This ruling applies for the following periods

Year ending 30 June 2016

The scheme commences on

1 July 2015

Relevant facts and circumstances

Company E is the trustee of the Fund. The Fund is a complying self-managed superannuation fund. The members of the Fund at 30 June 20XX were Person A, Person B, Person C and Person D who are all related. Person A and Person B are each currently in receipt of account based pensions from the Fund. The directors of Company E at 30 June 20XX were Person A, Person B, Person C and Person D.

Company E as trustee of the Fund holds all of the units in the Trust (a unit trust with Company F as trustee). These units are not in-house assets of the Fund. The units were acquired by the Fund during the year ended 30 June 19XX. The units were acquired by subscription and at the time the subscription proceeds were the only asset of the Trust. The directors of Company F are Person B, Person C and a child of Person A and Person B, Person G.

Along with other assets, the Trust holds all of the shares in a company; Company H. Company H holds real estate. Company H holds no other assets other than cash. The directors of Company H are Person A and Person B.

Whilst the shares in Company H have been owned by the Trust, the real estate has been exclusively, used as business premises by Person A. Prior to the Trust acquiring all the shares in Company H, Person A was renting the premises.

The shares in Company H were purchased at market value by the Trust from the previous owners. The previous owners are not related parties to Person A or their family. The price paid for the shares was based upon the value of the real estate at the time. The Trust borrowed part of the purchase price from a financial institution and used the proceeds of subscription for units in the Trust by the Fund to pay the balance of the purchase price.

The vendors were only prepared to sell the shares in Company H and not the real estate directly.

Since acquisition by the Trust, the real estate has been rented exclusively as a business to Person A. Rental has been set at what has been understood to be the commercial rental value of the premises. From time to time that rental value has been confirmed by discussion with local real estate agents.

In 20XX Company H entered into a Put and Call Option Agreement over the real estate. The options are exercisable in 20XX. On exercise of the options the disposal of the real estate will give rise to a capital gain to Company H.

There have not been any non-commercial loans or other non-arm's length transactions involving Company H.

The proceeds of sale of the real estate in Company H will be distributed to the Trust, as the 100% shareholder in Company H. After the sale of the real estate there would be no further use for Company H and hence, that distribution would most likely be by way of liquidation proceeds. Part of these proceeds would be deemed to be a dividend. The dividend would be franked. The balance would be a return of capital subscribed. In turn, Company F as trustee of the Trust will distribute its net income to its sole unitholder, Company E as trustee of the Fund.

The Fund would therefore receive the dividend indirectly via the Trust. It would also receive the return of capital being the proceeds upon disposal by the Trust of the shares in Company H. There may be a capital loss in the Trust on disposal (by cancellation) of the shares as the price paid would exceed the paid up capital.

The Trust has a family trust election in place. All investment assets held by the Trust were acquired from non-related parties. Rental income from each rent producing property has been at market rates. The Trust has only borrowed from banks on normal commercial terms and conditions.

Assumptions

The fixed entitlement to the income distributed from the Trust to the Fund to the extent that the amount is not sourced from the distribution the Trust receives from Company H:

• is not acquired under a scheme or any income derived under a scheme to which the parties are not dealing at arm's length; and

• the amount of the distribution for the income year is not more than the amount that the Fund might be expected to derive if the parties had been dealing with each other at arm's length.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 295-545

Income Tax Assessment Act 1997 section 295-550

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

Income Tax Assessment Act 1997 section 104-25

Income Tax Assessment Act 1997 section 118-20

Income Tax Assessment Act 1997 section 115-25

Income Tax Assessment Act 1997 section 202-45

Income Tax Assessment Act 1936 subsection 47(1)

Income Tax Assessment Act 1936 subsection 47(1A)

Income Tax Assessment Act 1936 subsection 47(2B)

Further issues for you to consider

This ruling decision is limited to the application of section 295-550 of the ITAA 1997 and has not otherwise considered the application of the substantive provisions of the ITAA 1997, the Income Tax Assessment Act 1936 (ITAA 1936) or the Superannuation Industry (Supervision) Act 1993 to the proposal.

Reasons for decision

Question 1

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

The note to subsection 295-545(1) of the ITAA 1997 explains that a concessional rate (15%) of tax applies to the low tax component, while the non-arm's length component is taxed at the highest marginal tax rate.

Subsection 295-545(2) of the ITAA 1997 provides that the non-arm's length component for an income year is the entity's non-arm's length income for that year less any deductions to the extent that they are attributable to that income. The phrase 'non-arm's length income' has the meaning given by section 295-550 of the ITAA 1997.

The Commissioner has issued Taxation Ruling TR 2006/7 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. This Ruling refers to former section 273 of the ITAA 1936 which concerned 'special income' (now termed non-arm's length income) and continues to provide the ATO view so far as the new provision (section 295-550 of the ITAA 1997) expresses the same ideas as section 273.

Given that the Fund holds a fixed entitlement to the income of the Trust due to its ownership of 100% of the units, subsection 295-550(5) of the ITAA 1997 is relevant. It provides that:

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 expected to derive if those parties had been dealing with each other at arm's length.

Entitlement acquired or income derived under a scheme

The term 'scheme' is defined in subsection 995-1(1) of the ITAA 1997 to mean:

(c) any *arrangement; or

(d) any scheme, plan, proposal, action, course of action or course of conduct, whether unilateral or otherwise.

The term 'arrangement' is also defined in subsection 995-1(1) of the ITAA 1997 to mean 'any arrangement, agreement, understanding, promise or undertaking, whether express or implied, and whether or not enforceable (or intended to be enforceable) by legal proceedings'.

The Full Court of the Federal Court in Allen v Federal Commissioner of Taxation (2011) 195 FCR 416 (Allen) considered the term 'arrangement' as defined for the purposes of former subsection 273(7) of the ITAA 1936 - the immediate predecessor of subsection 295-550(5) of the ITAA 1997. That term was defined in terms almost identical to a combination of the definitions of 'scheme' and 'arrangement' in the ITAA 1997. The Court held that the series of steps undertaken by the parties that resulted in the acquisition of a fixed interest in the trust estate and the relevant distributions of income from that trust estate were readily seen to be an 'arrangement' to which the various entities were parties, and whose results were readily seen to be the consequence of that arrangement.

Similarly, for the purposes of applying subsection 295-550(5) of the ITAA 1997 in the present case, the series of transactions to acquire and obtain income from the various entities is an arrangement to which the various entities were involved.

It is concluded that there is a scheme.

Whether parties are not dealing with each other at arm's length and the income is more than it might otherwise have been

In determining whether the parties deal at arm's length it is necessary to consider any connection between them and any other relevant circumstances (see the meaning of 'arm's length' in subsection 995-1(1) of the ITAA 1997).

It is clear that the parties in the present case are not at arm's length.

• Person A, Person B, Person C and Person D are the directors of Company E which is the trustee of the Fund with the four individuals the members of the Fund.

• Person B, Person G and Person C are the directors of Company F which is the trustee of the The Trust, all the units of this unit trust are owned by the Fund.

• Company F as trustee of the Trust owns all the shares in Company H (Person A and Person B are the directors of Company H).

• Company H owns a property from which Person A has been conducting a business.

The scheme therefore involves persons who are all connected themselves or entities which one or more of them together control or have an interest in.

As to whether or not they are dealing at arm's length, in Federal Commissioner of Taxation v. AXA Asia Pacific Holdings Ltd [2010] FCAFC 134 (Axa) Dowsett J (at [26]) summarised propositions, which emerge from the numerous cases in which the expression 'not dealing with each other at arm's length' (or similar) have been considered, as follows:

(a) in determining whether parties have dealt with each other at arm's length in a particular transaction, one may have regard to the relationship between them;

(b) one must also examine the circumstances of the transaction and the context in which it occurred;

(c) one should do so with a view to determining whether or not the parties have conducted the transaction in a way which one would expect of parties dealing at arm's length in such a transaction;

(d) relevant factors which may emerge include existing mutual duties, liabilities, obligations, cross-ownership of assets, or identity of interests which might enable either party to influence or control the other, or induce either party to serve a common interest and so modify the terms on which strangers would deal;

(e) where the parties are not in an arm's length relationship, one may infer that they did not deal with each other at arm's length, and that the resultant transaction is not at arm's length;

(f) however related parties may, in some circumstances, so conduct a dealing as to displace any inference based on the relationship;

(g) un-related parties may, on occasions, deal with each other in such a way that the resultant transaction may not properly be considered to be at arm's length.

Although Dowsett J dissented in the application of those propositions in that case, Edmonds and Gordon JJ did not disapprove of his summary of those propositions.

In that case Edmonds and Gordon JJ further stated that:

Any assessment of whether parties were dealing at arm's length involves 'an assessment [of] whether in respect of that dealing they dealt with each other as arm's length parties would normally do, so that the outcome of their dealing is a matter of real bargaining':..

Further, the Full Court of the Federal Court in Allen held that former paragraph 273(7)(a) of the ITAA 1936 - the immediate predecessor of paragraph 295-550(5)(a) of the ITAA 1997 - does not require that the 'dealing' consist only of the actual derivation of the income in question by 'the entity' but that the evident legislative intention of the provisions is to permit regard to be had to the totality of the steps that result in the entity's acquisition of its fixed entitlement to the income of the trust and any derivation of income by the entity through holding that entitlement.

In this case, it is consistent with Allen to consider the arrangement holistically to determine if income of the Fund which is the distribution from the Trust that includes the distribution from Company H is non-arm's length income.

There have been no non-arm's length transactions within the scheme therefore; subsection 295-550(5) of the ITAA 1997 would not apply to the Fund with respect to its receipt of the distribution from the Trust. The purchase by the Fund of the units in the Trust; the purchase by the Trust of the shares in Company H including the financing of the purchase of the shares; and the conduct of the transactions by Company H, including the gaining of rental income and the sale of the real estate to unrelated parties were all conducted on an arm's length basis even though some of the transactions were conducted between related entities. As such the income distributed from the Trust to the Fund is not more than the amount that the entity might have expected to derive if those parties had been dealing with each other at arm's length.

Question 2

Subsection 47(1) of the Income Tax Assessment Act 1936 (ITAA 1936) provides:

Distributions to shareholders of a company by a liquidator in the course of winding up the company, to the extent to which they represent income derived by the company (whether before or during liquidation) other than income which has been properly applied to replace a loss of paid-up share capital, shall, for the purposes of this Act, be deemed to be dividends paid to the shareholders by the company out of profits derived by it.

Subsection 47(1A) of the ITAA 1936 explains the phrase 'income derived by the company' in subsection (1) as follows:

(a) an amount (except a net capital gain) included in the company's assessable income for a year of income; or

(b) a net capital gain that would be included in the company's assessable income for a year of income if the Income Tax Assessment Act 1997 (ITAA 1997) applied.

The effect of subsection 47(1A) is that a dividend paid to a shareholder that represents company profit will be taxed in the hands of the shareholder in the same manner in which that profit was taxed in the hands of the company. For example, the distribution of a non-taxable capital gain made by a company (for example, from the sale of a pre-CGT asset) to a shareholder will also be non-taxable to the shareholder if that distribution is made in the course of wind up the company.

(Note: Subsection 47(2B) of the ITAA 1936 states where the company does not cease to exist within a period of three years after the distribution or within such further period as the Commissioner allows, then those moneys or other property so distributed shall be deemed to be dividends paid by the company to the shareholders out of ordinary profits derived by it. For example, the distribution of a non-taxable capital gain made by the company to a shareholder would be taxable to the shareholder.)

Taxation Determination TD 2001/27 explains the full amount of a final distribution made by a liquidator on the winding-up of a company constitutes capital proceeds from the ending of the shareholder's shares in the company (which is CGT event C2 in section 104-25 of the ITAA 1997). However, the anti-overlap provision in section 118-20 of the ITAA 1997 reduces any capital gain by amounts that are otherwise assessable as a result of the event (such as under section 47 of the ITAA 1936).

Section 115-25 of the ITAA 1997 provides (in general) a discount capital gain will result from a CGT event happening to a CGT asset that was acquired by the entity making the capital gain at least 12 months before the CGT event. The discount percentage is 50%.

Section 202-45 of the ITAA 1997 lists the types of distributions that are unfrankable, the list does not include distributions to shareholders of a company by a liquidator in the course of winding up the company.

Therefore, section 202-45 of the ITAA 1997 does not prohibit a (partially) franked dividend.

Since the payment or part of the payment of the liquidator's distribution from Company H to the Trust is deemed to be a dividend and is not prohibited from being a franked dividend, the inclusion of this amount in the distribution of net income from the Trust to the Fund will include the franking credit and the Fund will be entitled to a franking credit tax offset in respect of the franking credit.

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