Edited version of your written advice

Authorisation Number: 1012768448399

Ruling

Question

Will dividends paid from a private company to the superannuation fund be non-arm's length income under section 295-550 of the Income Tax Assessment Act 1997?

Advice/Answers

No.

This ruling applies for the following period

Year ended 30 June 2014

Year ending 30 June 2015

The scheme commenced on

1 July 20XX

Relevant facts and circumstances

The Fund is a complying superannuation fund which was established in the year ended 30 June 20XX.

The members of the Fund are spouses.

The trustee of the Fund is a corporate trustee whereby the directors are the members of the Fund.

During 2012-13 and 2013-14 income year the trustee of the Fund purchased shares in a private company (the Company), on behalf of the Fund.

The Company, which is domiciled in Australia, provides a number of management and planning services.

The Company was incorporated during the 1970-71 income year and, through its wide network of offices, employs a large number of personnel.

The Company is wholly owned by senior staff and in accordance with its Constitution, shareholding is limited to employees and employee associated entities.

As at 30 June 20YY, employee shareholders numbered in the hundreds.

The largest shareholder in the Company, one of the directors, owns a small proportion of the Company's issued share capital.

None of the major shareholders of the Company are related to each other.

No member or trustee of the Fund is a director of the Company. No director of the Company is connected to any member or trustee of the Fund.

One of the members of the Fund is an employee of the Company.

The value of the shares purchased by the Fund was determined by the Company's board. On 1 July each year, the Company's board establishes a valuation based on the greater of:

(1) the Company's net assets per share at the relevant balance date; or

(2) an earnings based method which takes into account the estimated sustainable earnings. This is based on recommendations by the Finance Committee, the profitability of the Company over previous years and an appropriate Price/Earnings ratio.

There is only one class of shares and all shares in the Company receive the same rate of dividend. The Company's shares are fully paid ordinary shares with equivalent rights and entitlements. Voting rights attached to the shares are one vote per share in the Company.

Dividends are paid from the Company's profits and are only paid in cash. Further, the Company does not pay dividends:

(i) in the form of shares;

(ii) as a form of remuneration; nor

(iii) as part of an employee share scheme.

To ensure Company profits are distributed evenly across a year, so shareholders who held shares for only part of a year are not disadvantaged, the Company pays dividends to all shareholders who held shares during the quarter to which a dividend relates.

The trustee of the Fund's decision to purchase shares in the Company took into account:

(i) the member, as an employee, was presented the opportunity to acquire parcels of shares in the Company;

(ii) the Company's record of growth;

(iii) the rate of dividends paid; and

(iv) the investment in the Company agreed with the Fund's strategy of medium to long term investments to increase member's benefits over time. Included in this strategy was the Fund investing in listed and unlisted equities.

The shares were fully paid and purchased from shareholders of the Company who were also employees of the Company. The purchase of shares was financed by the Fund's cash reserves.

The Company issued a catch up dividend in the 2013-14 income year whereby shareholders were able to reinvest in shares.

You state that the Company's dividend payout ratio is comparable to the rate paid by listed companies in the same industry.

During the year ended 30 June 2014 the Fund received fully franked dividends from the Company.

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).

Further issues for you to consider

Not applicable.

Anti-avoidance rules

Not applicable.

Reasons for decision

Summary of decision

The Commissioner is of the opinion that the transactions involving the payment of dividends by the Company to the Fund will produce an arm's length outcome. Therefore the dividends paid by the Company to the Fund will not be considered non-arm's length income of the Fund.

Detailed reasoning

In accordance with section 295-545 of the Income Tax Assessment Act 1997 (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'.

The non-arm's length component (formerly known as special income) comprises non-arm's length dividends received from private companies, non-fixed interest trust distributions, and income derived from transactions where the parties are not dealing with each other at arm's length and the amount derived is more than might be expected in an arm's length dealing. 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).

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'. This ruling refers to the former section 273 of the Income Tax Assessment Act 1936 (ITAA 1936) which concerned 'special income' and still provides useful guidance on the factors to be considered in the interpretation of section 295-550 of the ITAA 1997.

Subsection 295-550(2) of the ITAA 1997 states that dividends paid to a complying superannuation fund by a private company will be non-arm's length income of the fund unless the amount is consistent with an arm's length dealing. In other words, is the dividend the same for the complying superannuation fund as it would be for any other shareholder? The factors listed in subsection 295-550(3) are to be considered in deciding whether there has been an arm's length result.

Consequently, the Commissioner will consider if dividends paid to the Fund by the Company produces an arm's length result.

Dividends

In applying subsection 295-550(3) of the ITAA 1997 to the facts of this case, the Commissioner will consider the factors described in paragraphs 295-550(3)(a) to (f) that indicate whether or not the dividends are consistent with an arm's length dealing. Further, the Commissioner will consider any other matter considered to be relevant under paragraph 295-550(3)(f).

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) of the ITAA 1997 states:

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.

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

Paragraphs 295-550(3)(a) and (b):

The entity in this case is the Fund. The Company is wholly owned by senior staff and in accordance with its Constitution, shareholding is limited to employees and employee associated entities. As at 30 June 2014 employee shareholders numbered in the hundreds.

The largest shareholder in the Company, one of the directors, owns a small proportion of the Company's issued share capital.

The value of the shares purchased by the Fund was determined by the Company's board. On 1 July each year, the Company's board establishes a valuation based on the greater of:

(i) the Company's net assets per share at the relevant balance date; or

(ii) an earnings based method which takes into account the estimated sustainable earnings. This is based on recommendations by the Finance Committee, the profitability of the Company over previous years and an appropriate Price/Earnings ratio.

The shares were fully paid and purchased from shareholders of the Company who were also employees of the Company. The purchase of shares was financed by the Fund's cash reserves.

It is considered that the shares have been objectively valued and that the market value is reasonable. Therefore it is considered that the value of the shares acquired by the Fund was determined on an arm's length basis.

Overall, it is considered that these factors are favourable to the Commissioner considering the income of the Fund to be arm's length income.

Paragraphs 295-550(3)(c) and (d):

There is only one class of shares and all shares in the Company receive the same rate of dividend. Therefore, the Fund will receive an amount which is applicable to all other shareholders of the Company.

You have provided the last dividend paid by the Company. You state that the Company's dividend payout ratio is comparable to the rate paid by listed companies in the same industry.

Overall, in view of the above, it is considered that these factors are favourable in respect of the Commissioner considering the income to be arm's length income.

Paragraph 295-550(3)(e):

The Company issued a catch up dividend in the 2013-14 income year whereby shareholders were able to reinvest in shares. All shareholders were given the same ability to reinvest.

This will be a neutral factor in determining if there is an arm's length outcome.

Paragraph 295-550(3)(f):

As noted earlier, the Company was incorporated during the 1970-71 income year and, through its wide network of offices, employs a large number of personnel.

None of the major shareholders of the Company are related to each other.

One of the members of the Fund is an employee of the Company. However, there is nothing to indicate that the members of the Fund may influence, or are in a position to significantly affect, the decisions of the Company including the timing and amount of the payment of dividends.

Therefore, the state of the relationship between the members of the Fund and the Company is a positive factor.

The source of the funds used by the Fund to acquire the shares in the Company may have an influence on the decision made by the Commissioner. In this case, the shares were fully paid and purchased from shareholders of the Company who were also employees of the Company. The purchase of shares was financed by the Fund's cash reserves.

It is also relevant to consider whether the profits of the Company are largely dependant on the efforts of key personnel (such as a director) who are also members of the Fund. In this case, no member or trustee of the Fund is a director of the Company. Further, no director of the Company is connected to any member or trustee of the Fund.

Conclusion:

On the whole, having regard to 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 payment of dividends by the Company to the Fund will produce an arm's length outcome.

Therefore, the dividends paid by the Company to the Fund will not be considered non-arm's length income of the Fund as defined by section 295-550 of the ITAA 1997.