Edited version of private advice

Authorisation Number: 1052203491461

Date of advice: 15 December 2023

Ruling

Subject: Non-arm's length income

Question

Was the capital gain made by the Trustee for the Superannuation Fund (the Super Fund) non-arm's length income (NALI) within the meaning of section 295-550 of the Income Tax Assessment Act 1997?

Answer

No

This private ruling applies for the following period:

Income year ended 30 June 20XX

Relevant facts and circumstances

The Super Fund is a complying superannuation entity and a self managed superannuation fund. The Super Fund has two members, Person A and Person B, both of whom are directors of the Corporate Trustee.

In 20XX, Person B was approached by Person C, a business colleague and friend, to become involved in a company (the Company). On behalf of the Company, Person C issued a letter to Person B dated XX XX 20XX welcoming Person B to the board of the Company. Person B was asked to be an independent director of the Company, and possible chairman. They were registered as a director on XX XX 20XX.

On XX XXXX 20XX the Company resolved to issue the Trustee with the right to invest in shares (options), at a price established in the next financing round not involving existing shareholders. The options issued to the Trustee had an expiry date of July 20XX.

At the time of issue no market value was attributed to the options by the Trustee due to the net position of the Company.

Between 20XX and 20XX the Company acquired businesses paid for from funds raised from an investment company via the issue of preference shares. In 20XX, discussions commenced regarding the acquisition of the Company and its subsidiaries by a third party. One of the terms of the acquisition was that any issued options and preference shares would need to be paid out prior to the completion of the sale.

Following some negotiations between Person B and the other directors (who were also shareholders of the Company), it was agreed that the Company would pay an amount to the Super Fund in return for the cancellation of the options held by the Trustee. Payment was made to the Super Fund in the 20XX income year, and declared as NALI in the Super Fund's 20XX income tax return.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 104-25

Income Tax Assessment Act 1997 paragraph 104-25(1)(a)

Income Tax Assessment Act 1997 subsection 104-25(3)

Income Tax Assessment Act 1997 subsection 108-5(1)

Income Tax Assessment Act 1997 Subdivision 115-A

Income Tax Assessment Act 1997 Division 295

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

Income Tax Assessment Act 1997 subsection 295-545(2)

Income Tax Assessment Act 1997 section 295-550

Income Tax Assessment Act 1997 subsection 295-550(1)

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

Reasons for decision

All subsequent legislative references are to the Income Tax Assessment Act 1997.

Summary

The capital gain made pursuant to the happening of CGT event C2 in respect of the options held by the Trustee was not NALI of the Super Fund within the meaning of section 295-550.

Detailed reasoning

An option is a CGT asset as defined in subsection 108-5(1). CGT event C2 happens when the ownership of an intangible CGT asset ends due to it being cancelled (paragraph 104-25(1)(a)). A capital gain is made if the capital proceeds from the ending are more than the asset's cost base, and a capital loss is made if those capital proceeds are less than the asset's reduced cost base (subsection 104-25(3)).

Division 295 sets out special rules about the taxation of superannuation entities.

The taxable income of a complying superannuation entity is split into a non-arm's length component and a low tax component (subsection 295-545(1)). The non-arm's length component for an income year is the entity's NALI for that year less any deductions to the extent they are attributable to that income (subsection 295-545(2)).

According to subsection 995-1(1), the phrase 'non-arm's length income', as it applies to complying superannuation entities, has the meaning given by section 295-550. Relevantly, subsection 295-550(1) provides:

An amount of ordinary income or statutory income is non-arm's length income of a complying superannuation entity if, as a result of a scheme the parties to which were not dealing with each other at arm's length in relation to the scheme, one or more of the following applies:

(a)          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 in relation to the scheme;

(b)          in gaining or producing the income, the entity incurs a loss, outgoing or expenditure of an amount that is less than the amount of a loss, outgoing or expenditure that the entity might have been expected to incur if those parties had been dealing with each other at arm's length in relation to the scheme;

(c)          in gaining or producing the income, the entity does not incur a loss, outgoing or expenditure that the entity might have been expected to incur if those parties had been dealing with each other at arm's length in relation to the scheme.

This subsection does not apply to an amount to which subsection (2) applies or an amount derived by the entity in the capacity of beneficiary of a trust.

The definition of 'arm's length' in subsection 995-1(1) provides that in determining whether parties deal at arm's length, consider any connection between them and any other relevant circumstance.

In Federal Commissioner of Taxation v AXA Asia Pacific Holdings Ltd (2010) 189 FCR 204, at 213 Dowsett J summarised propositions which emerge from the numerous cases in which the expression 'not dealing with each other at arm's length' or similar expressions have been considered, as follows:

•                     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

•                     one must also examine the circumstances of the transaction and the context in which it occurred

•                     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

•                     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

•                     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

•                     however related parties may, in some circumstances, so conduct a dealing as to displace any inference based on the relationship, and

•                     unrelated 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.

In that case Edmonds and Gordon JJ, who did not disapprove of Dowsett J's summary of those propositions, further stated at 231 that:

Any assessment of whether parties were dealing at arm's length involves 'an assessment 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' ...

The payment received by the Trustee from the Company was consideration for the cancellation of its options to acquire shares in the Company. The cancellation of those options was a condition of the sale of the Company to a third party.

Person B was not a shareholder of the Company at any time, and there is no evidence or reason to suggest that they could influence or control the Company in relation to the payment the Trustee received from the Company in respect of the cancellation of the Trustee's options. The amount of the payment was ultimately agreed upon following negotiations between Person B (on behalf of the Trustee) and the other directors of the Company.

Therefore:

•                     for the purposes of subsection 295-550(1), it is not considered that the parties were 'not dealing with each other at arm's length', and

•                     the payment received by the Trustee from the Company was not NALI, and did not constitute all or part of the non-arm's length component of the Super Fund for the 2022 income year.

CGT event C2 under section 104-25 happened to the Super Fund upon cancellation of the options (at the time of their cancellation). The capital gain made by the Super Fund from that event was a discount capital gain under Subdivision 115-A.