Edited version of private advice

Authorisation Number: 1052314103521

Date of advice: 7 November 2024

Ruling

Subject:Employee share scheme

Question

Do the non-arm's length income (NALI) provisions have any application to a Fund where a member makes a contribution to the Fund of Employer Company share options that the member acquired under an Employee Share Scheme (ESS), which the Fund then exercised to acquire ordinary shares in the Employer Company?

Answer

No, the NALI provisions will not apply to the Fund in respect of the member's contribution of share options recorded in the Fund's account at market value; and in respect of the shares based on its acquisition by the Fund when it exercised its options on the particular facts of this case.

This ruling applies for the following periods

Year ending 30 June 20XX

The scheme commences on

01 July 202X

Relevant facts and circumstances

The Fund is a self-managed superannuation fund (SMSF) with two members. One member is an employee of the Employer Company and the other member is the Employee's spouse. The trustee of the SMSF is a company (the Trustee). The Employee and their spouse are shareholders and directors of the Trustee.

Employee Share Scheme

The Employer Company adopted certain rules (ESS rules) for its ESS Plan. Under the ESS rules, the Employer Company Board may invite 'Eligible Employees' to participate in a grant of incentive securities, which may comprise 'Rights', 'Options', and 'Restricted Shares'.

Under the ESS rules an 'Eligible Employee' includes:

(a)          a full time or part time employee of a Group Company (including a Director)

(b)          a non-executive Director of a Group Company

(c)          a Casual Employee

(d)          a contractor, or

(e)          any other person who is declared by the Board to be eligible to receive a grant under the ESS Plan.

Under the ESS Plan, options are offered to eligible employees (or their nominees, including a corporate trustee of a self-managed superannuation fund of which an employee is a director) to acquire the Employer Company shares.

The Employer Company made offers to the Employee under the ESS Plan to acquire options.

The Employee nominated the Trustee to participate in the ESS Plan and acquire the Employer Company options.

The Employer Company offered the scheme to all permanent staff members on equivalent terms. The offer varied based on the seniority of the staff member but did so consistently across all staff members. The Employee could not influence the Employer Company's decision to make the offer, the quantity of options offered or the price at which the options are exercised.

ESS Plan Options and Shares acquired by the Fund

The Employee entered into the ESS Plan and nominated the Fund under the ESS Plan terms for the options in respect of the Employer Company shares.

The Employee made a contribution to the Fund of the options and the Fund recognised that contribution in their accounts for the income year at market value as a non-concessional member contribution.

The assessed fair value of the options was independently determined using the Black Scholes Model.

Each option permitted the acquisition of one ordinary share. The Fund exercised all options it acquired, resulting in the Fund acquiring ordinary shares in the Employer Company at the set price determined under the ESS Plan.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 295-550

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

Income Tax Assessment Act 1997 paragraph 295-550(1)(b)

Income Tax Assessment Act 1997 subsection 295-550(8)

Income Tax Assessment Act 1997 subparagraph (8)(a)(ii)

Income Tax Assessment Act 1997 section 995-1

Reasons for decision

All references are to the Income Tax Assessment Act 1997, unless otherwise stated.

Paragraph 4 of Taxation Ruling TR 2010/1DC Income tax: superannuation contributions (TR 2010/1DC) provides that a contribution is:

In the superannuation context, a contribution is anything of value that increases the capital of a superannuation fund provided by a person whose purpose is to benefit one or more particular members of the fund or all of the members in general.

Paragraphs 6-7 of TR 2010/1DC provide that for an increase in the capital of the fund to be a contribution it must be made with the intention of benefiting one or more fund members. This intention is determined objectively based on the circumstances, not the person's subjective intention.

Paragraph 18 of TR 2010/1DC provides that an in-specie contribution will occur when the fund's capital is increased where a person transfers an asset to the superannuation fund but the fund pays no consideration or less than market value for the asset.

Paragraph 25B of TR 2010/1DC provides that:

An in specie contribution is required to be reflected at its market value in the fund's accounts and the member's superannuation interest. That is, the amount of the member's contribution is equal to the market value of the in specie contribution... Further, the amount of the contribution for the purposes of applying the concessional and non-concessional contributions cap rules is the market value of the asset.

Contribution of the Options

The Employee under the ESS Plan, could and did nominate the Fund to receive the options under the ESS Plan scheme they participated in.

The options were recognised by the Fund at market value (as independently determined using the Black Scholes Model) in the member accounts.

On the facts, contributions were made by the Employee to the Fund as the capital of the Fund was increased directly by the market value of the options, for the intended purpose of benefitting the members of the Fund.

Non-Arm's Length Income (NALI)

Subsection 295-550(1) provides that an amount of ordinary or statutory income of a complying superannuation fund is NALI 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)          if the entity is of a kind referred to in paragraph (8)(a) (about certain small entities):

(i)            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; and

(ii)            subsection (8) does not apply to the loss, outgoing or expenditure;

(c)          if the entity is of a kind referred to in paragraph (8)(a) (about certain small entities):

(i)            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; and

(ii)            subsection (9) does not apply to the loss, outgoing or expenditure that the entity might have been expected to incur.

Paragraph 25A of TR 2010/1DC states:

25A. The acquisition of an asset by a superannuation provider is not a contribution referred to in paragraph 18 of this Ruling (an in specie contribution) where the asset is purchased from an entity under a sale contract. However, an in specie contribution may be made in conjunction with the purchase of an asset. This may occur, for example, where 50% of the asset is purchased with the remaining 50% of the asset being subject to an in specie contribution...

The options were contributed by the Employee when the Fund was nominated by them in respect of those options under the ESS Plan. The options were also recorded at market value in the Fund's accounts.

As such, in respect of the nomination by the Employee under the ESS Plan, the NALI provisions will not apply to the options, as these were contributed to the Fund and recorded at market value.

Acquisition of the Shares

The Fund, in exercising the options, acquired shares in the Employer Company directly at a specified price and within a specified timeframe. This acquisition of the shares was at a price below their market value.

Paragraph 25C of TR 2010/1DC states:

25C. In circumstances where a superannuation provider purchases an asset under a contract at less than market value, the superannuation provider has incurred non-arm's length expenditure under a non-arm's length dealing for the purposes of applying the 'non-arm's length income' provisions in section 295-550. We do not consider that the difference between the consideration paid (if any) and the market value represents an in specie contribution being made as the asset has been acquired under the terms of the contractual agreement and not through an in specie contribution.

As such, when exercising the options, the Fund made an acquisition of the Employer Company shares and there was no contribution in respect of the acquisition of the Employer Company shares to the Fund. As the shares were acquired by the Fund at less than market value, consideration of the application of the NALI provisions is required.

Subsection 295-550(1) provides that an amount of ordinary or statutory income of a complying superannuation fund is NALI where, 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 requirements in paragraphs 295-550(1)(a) to (c) applies.

An essential element of paragraph 295-550(1)(a) is for the parties to not have been dealing with each other at arm's length in relation to the scheme. Arm's length is defined in section 995-1 as:

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

Paragraph 295-550(1)(b) is the main provision for consideration on these facts. It provides that the income derived in respect of the Employer Company shares by the Fund (being of a kind referred to in subparagraph (8)(a)(ii) as an SMSF), will be NALI where:

•                     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; and

•                     subsection (8) does not apply to the loss, outgoing or expenditure - which refers to general non-arm's length expenditure.

In this case, paragraph 295-550(1)(b) is the more relevant provision in section 295-550 and is to be considered as the Employer Company shares were acquired by the Fund at a price set by the ESS Plan which is below market value. Further, subsection 295-550(8) does not apply in this case as in gaining or producing the income, the Fund incurs a loss, outgoing or expenditure in respect of a particular asset (the Employer Company shares). Accordingly, the expenditure is not a general non-arm's length expense.

Law Companion ruling LCR 2021/2 - Non-arm's length income - expenditure incurred under a non-arm's length arrangement clarifies how section 295-550 operates in a scheme where the parties do not deal with each other at arm's length.

Paragraph 51 of LCR 2021/2 states:

A complying superannuation fund might enter into arrangements that result in it receiving discounted prices. Such arrangements will still be on arm's length terms where they are consistent with normal commercial practices, such as an individual acting in their capacity as trustee (or a director of a corporate trustee) being entitled to a discount under a discount policy where the same discounts are provided to all employees, partners, shareholders or office holders.

The ESS Plan was offered to all permanent staff members on equivalent terms. The offer varied based on the seniority of the staff member but did so consistently across all staff members. The Employee could not influence whether they received an offer, the quantity of options offered or the price to exercise the options and acquire the shares.

Based on the specific facts of this case, the NALI provisions will not apply in respect of the Employer Company shares acquired by the Fund when exercising the options at the set price, under the ESS Plan. The discounted prices for which the shares were acquired by the Fund were on arm's length terms and consistent with the normal commercial practices of the Employer Company.