Edited version of private ruling

Authorisation Number: 1011823981710

NOTICE

This edited version has been found to be misleading or incorrect. It does not represent the ATO’s view of the relevant law.

This notice must not be taken to imply anything about:

● the binding nature of the private advice issued to the applicant

● the correctness of other edited versions.

Ruling

Subject: Non-arm's length income

Question:

Will the amount of private company dividends and attached franking credits proposed to be received by the superannuation fund constitute non-arm’s length income?

Answer:

No

This ruling applies for the following period:

Year ended 30 June 2011

The scheme commenced on:

1 July 2011

Relevant facts and circumstances:

The Fund was established over 10 years ago.

The Fund has a corporate trustee.

The Fund has only one member (the Member).

The Member’s late parent (the deceased), owned all the shares in a private company (the Company).

The issued capital of the Company is fully paid ordinary shares.

The Company is an ungeared company and the major asset of the Company is real property.

The property is leased to an unrelated party that uses it in their business.

The rental income from the property is derived on an arm’s length basis from the unrelated party.

Upon the death of the deceased, the Member and the Member’s siblings each inherited an equal percentage of the shares in the Company.

Currently, the Member of the Fund, the Member’s Property Trust (the Trust), and one of the member’s sibling’s wholly own the shares in the Company.

The directors of the Company are the Member and the other sibling shareholder.

The Fund wishes to acquire the other remaining shareholder’s interest and the interest owned by the Trust.

The Member of the Fund will use their non-superannuation assets as security for the Bank loan. It is expected the Bank will charge interest rate of less than 10%.

The Member will then loan the money to the Fund to acquire shares from the related parties. The Member will charge an interest rate higher than the Bank rate on the loan to the Fund.

Recently, you have provided a copy of an appraisal of the property conducted by a real estate firm, which estimates the market value of the property. In determining, the market value of the property, a copy of the lease agreement has been provided to the real estate firm.

You also provided another valuation conduct by another real estate firm. In their opinion the current market value of the property is within a range slightly lower than the appraisal value.

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 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 Section 66.

Superannuation Industry (Supervision) Act 1993 Part 8.

Taxation Administration Act 1953 Subsection 359-35 of Schedule 1.

Taxation Administration Act 1953 Paragraph 359-35(2)(a).

Taxation Administration Act 1953 Paragraph 359-35(2)(b).

Taxation Administration Act 1953 Subsection 359-35(3).

Taxation Administration Act 1953 Subsection 357-105(2).

Taxation Administration Act 1953 Paragraph 357-110(1)(a)

Taxation Administration Act 1953 Section 357-120.

Reasons for decision

Summary

After considering the matters listed in the legislation, the Commissioner is of the opinion that the proposed transactions involving the acquisition of the shares by the Fund will not result in the future payment of the dividends by the Company to the Fund being ‘non-arm’s length income’.

In making this decision, the Commissioner has not considered the following matters under the Superannuation Industry (Supervision) Act 1993 (SISA):

● the borrowing rules;

● the in-house asset rules; and

● that the investments have not been acquired from a related party.

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 Income Tax Assessment Act 1997 (ITAA 1997).

The non-arm’s length component (formerly known as special income) includes non-arm’s length dividends received from private companies, trust distributions where there is no fixed entitlement to the income, 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).

Non-arm’s length income

Section 295-550 of the ITAA 1997 states that:

(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.

(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.

(3) 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.

In this case, the Fund proposes to acquire shares from related parties and will be receiving dividends from a private company (the Company). As such, paragraph 295-550(2)(a) applies to any dividends received.

The Commissioner will consider paragraphs 295-550(3)(a) to (f) of the ITAA 1997 in determining 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) 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):

The entity in this case is the trustee of the Fund which is a complying superannuation fund.

The Company was incorporated a number of years ago. Since incorporation, the Company has issued fully paid ordinary shares.

The principal activity of the Company is receiving rental income from a commercial real property.

The shares in the Company were originally owned by the Member’s late parent (the deceased). Upon the death of the deceased, the Member, the Member’s siblings each acquired an equal interest in the Company.

Currently, there are three shareholders, the Member, the Trust and one of the siblings.

From the documentation supplied in relation to the acquisition of the shares, there is only one class of shares in the Company.

All the shares issued by the Company are fully paid up and participate equally in dividends.

The Fund intends to acquire the remaining shares of the Company from the related parties (the Trust and the sibling). The acquisition cost per share will be determined by an independent valuer.

Therefore, it is accepted that where the shares purchased by the Fund are acquired at the value determined by the independent valuer, the value and the cost of the shares acquired will be identical.

It is proposed to accept that the value of the shares is reasonable, and not such that should cause the Commissioner to treat the dividends as non-arm’s length income. Accordingly, this is a favourable factor in determining if there is an arm’s length outcome.

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 ‘unrelated’ shareholders of the company.

The Company has one class of shares on issue, all of which are fully paid up.

If the proposed acquisition occurs, the Fund and its Member will own all the shares in the Company. Consequently, the Fund as sole shareholder will be in a position to significantly influence the operations of the Company, including the payment of dividends.

However, as there is only one class of shares and all shares are all fully paid up, the rate of dividend received by the Fund will be identical for all its shares in the Company. As the dividends arise as a result of the rental income generate from the commercial real property it is accepted that the rate of dividends to be received will not be excessive in relation to the profits of the Company. In addition, the commercial real property is leased to an unrelated party and the rent received is paid at a market rate.

The financial statement of the Company provided indicates that the value of the net assets of the Company for the 2007-08 and 2008-09 income years respectively reflect those retained profits and reserve.

The current market value of the property, however, is not reflected in the Company’s balance sheets for the 2007-08 and 2008-09 income years as the assets were valued in the accounts at cost.

The dividend that is intended to be paid will be identical for all shares issued in the Company. There is no evidence that the rate of the dividend will be excessive in relation to the profits of the Company. The dividends were declared based on recent profits and the ability of the Company to continue operating normally.

It is proposed to accept that the dividends to be paid by the Company are not being paid in such a way that should cause the Commissioner to treat the dividends as non-arm’s length income.

Accordingly, this is a favourable factor in determining if there is an arm’s length outcome.

Paragraph 295-550(3)(e):

Franking dividends were paid to the shareholders in the 2007-08 and 2008-09 income years respectively, based on their shareholding. The dividends have been paid in cash and no shares were issued in lieu of cash dividends to any of the shareholders.

There were no shares issued by the Company in satisfaction of dividends. The Company financial statements show issue and paid up capital has not exceeded the original allotment of fully paid ordinary shares.

This is considered to be a neutral factor in determining if there is a non-arms length outcome.

Paragraph 295-550(3)(f):

As previously mentioned, all the shares in the Company were originally owned by the deceased. Upon the death of the deceased, the deceased’s children inherited the shares.

Although the current shareholders of the Company and the Fund are clearly not at arm’s length from each other, Justice Davies stated in Barnsdall v. Federal Commissioner of Taxation (1988) 81 ALR 173; (1988) 19 ATR 1352; (1988) 88 ATC 4565, that:

...I accept Mr McCarthy's submission that there may be transactions between related parties in which the parties deal with each other at arm's length. This may occur notwithstanding a close relationship between the parties or the power of one party to control the other.

Where the superannuation fund acquires the shares at a bona fide market value, reflecting the current value of the property, as proposed, as well as value of the company as a going concern, the Commissioner will accept that the value of the shares will be acquired at an arm’s length value.

The Member proposes to borrow money from a commercial bank, using his personal, non-superannuation, assets as security. The Member then intends to on-loan the money to the Fund on a non-recourse basis in a way that complies with SISA.

To reflect the added risk of the non-recourse loan, the Member will charge the Fund an interest rate slightly higher than the rate applying to the Member’s personal loan from the Bank.

It is considered that this approach is consistent with an arm’s length dealing between the member and the Fund, and will produce an arm’s length outcome.

It is also noted that the Member of the Fund is one of the two directors of the Company. There is no evidence that the Member has previously acted in a non-arm’s length manner that would cause the Commissioner to treat the dividends received or to be received as being non-arm’s length income.

It is relevant to consider whether the profits of the private company are largely dependant on the efforts of key personnel (such as a director) who are also members of the Fund where less than market salary is being paid to those key employees. As previously mentioned, the Member is one of the two directors of the Company. As per the financial statement of the Company it appears that no director’s fees have been paid to either the Member or the other director.

Although the Member of the Fund and the Fund may have influence over the issue of dividends and franking credits, in the event of the sale of the Company’s assets, all the retained profits of the Company will be paid as dividends before the Company is wound up.

At this stage, the proposed arrangement has not yet commenced. However, there is no indication that the Member and the Fund will act in a way that would cause the Commissioner to hold the dividends to be received as non-arm’s length income.

The Fund is principally for the benefit of the sole member. It is the Commissioner’s view that the more members of a superannuation entity who are at arm’s length to the private company, the more likely the Commissioner will conclude that it is reasonable to treat the dividends from the private company as not being special income.

In this case, the Member of the Fund, who is not at arm’s length to the Company, will benefit from dividends paid to the Fund. The acquisition of shares from the Company will provide an opportunity for concessional treatment to income that would otherwise be attributed to a high rate taxpayer, that is, have the Member of the Fund receive the income in a personal capacity; it would have been subject to tax at a higher marginal rate.

Overall, the other relevant matters considered above are considered a neutral factor in determining if there is an arm’s length outcome.

Conclusion:

After considering the matters listed in paragraphs 295-550(3)(a) to (f) of the ITAA 1997, the Commissioner is of the opinion that the dividends to be received by the Fund will not be ‘non-arm’s length income’ as defined in subsection 295-550(2) of the ITAA 1997.