Private ruling: Non-arm's length income
Date of advice: 5 September 2016
Published: November 2016
Ruling period: Year ended 30 June 2017
Date scheme commenced: 1 July 2016

Ruling: Q1: Will dividends to be paid by a private company to a self-managed superannuation fund be considered non-arm's length income for the purposes of subsection 295-550(2) of the Income Tax Assessment Act 1997 (ITAA 1997)? | A1: No | Q2: Will the answer to the question above be different if the directors who are also the members of the superannuation funds, are not remunerated at the market rate, instead they are rewarded by ways of using company cars and being reimbursed for the related expenses? | A2: Yes

Relevant facts and circumstances: The self-managed superannuation fund (Fund 1) was established almost a decade ago. The trustee of Fund 1 is a corporate trustee of which the directors are the Fund's members, A and B. You state that Fund 1 intends to acquire a shareholding in a private company (the Private Company). The Private Company's directors are member A and C (the member of another self-managed superannuation fund (Fund 2)). The current equal shareholders in the Private Company are Family Trust 1 and Family Trust 2. The shares in the Private Company are all fully paid ordinary shares. You state the Private Company, when it was set up: • had no value by itself in that it was merely shell company; • the initial issue price of the shares to the Family Trusts was a nominal paid by each to reflect the value of the Private Company when it was first established. The Private Company was established as a holding company and will purchase all issued shares in another company (Company X). The directors of Company X are A and C. Company X has not historically made payment to the directors in relation to their services rendered but were compensated in kind and the reimbursement for all relevant outgoings. The current equal shareholders in Company X are the Family Trusts (Family Trust 1 and Family Trust 2). The Family Trusts are in a partnership (the Partnership) that owns assets which are leased to Company X under a formal lease agreement. You have provided the methodology used by the directors to determine the lease amount and advised the risks the Partnership bears based on a number of factors. The Partnership and Company X deal with each other on an arm's length basis. The partners are unrelated and neither are under the control or influence of other. Each partner considers their own interest during the process to determine how much lease to be charged and ensure that the lease charged will be on commercial terms. Consequently, the parties in the Partnership are dealing with each other on an arm's length basis. Another company will be established in the future to purchase the assets that are required by Company X. This company will be a wholly owned subsidiary of the Private Company. The family groups are not connected except in the current business operations in Company X and the Partnership. None of the members of Fund 1, or those Fund 2, which also intends to purchase shares in the Private Company, are in business ventures with each other nor are there other dealings between the Partnership and any person or entity in either the family groups. No one party exercises influence over the other in relation to the operations of the business operated by Company X. As the business operated by Company X has grown it is intended to divert some operational risk to the separate entities which will be ultimately controlled by these same parties. This process will also enable the further development of Company X's core business. In order to achieve the intended results, the proposed restructure involves the formation of a consolidated group between the existing business and the Private Company. As part of the restructuring process, the Private Company is going to issue shares to raise the required capital to purchase the shares from Company X's shareholders. The Private Company will purchase the shares in Company X at market value at the time of the transfer. The price at which Company X is to be sold will be determined by an independent valuer. An estimated value has been provided. The Private Company intends to issue further ordinary shares to another unrelated entity (Other entity) and the Funds. The price of the shares to be issued to other entity and the Funds will be determined by the underlying value of Company X after the Private Company acquires the shares in that company. The then value of Company X will be determined by an independent and qualified valuer. The Funds purchase of the shares will be sourced from cash readily available to them and the members' non-concessional contributions made to them. All the shares will carry the same rights to capital and income of the Private Company and they will have the same rights to cast the vote at the shareholders meetings. The number of shares to be issued to the Funds in the private company are to be determined but the shareholding of each Fund in the Private Company is limited. You have stated that the current constitution of the Private Company will, prior to the Funds purchasing the shares in the Private Company be amended. You have stated that the current constitution of Company X will, prior to the Funds purchasing the shares in the Private Company, be amended. The intended shareholders in the Private Company and their respective shareholdings as a result of the proposed restructure have been provided as : Shareholder Shareholding Fund 1 X% Fund 2 X% Family Trust 1 XX% Family Trust 2 XX% Other entity Y% Soon after the purchase, the Private Company and Company X will form a consolidated group. The Partnership will continue to lease assets to Company X and a new incorporated subsidiary of the Private Company will purchase assets required by the business and lease them to Company X at commercial rates. The Private Company will not conduct any active business itself. It merely holds the shares in the subsidiaries. All payments in relation to the dividend declared in the future by the Private Company will be sourced from the cash within the consolidated group. The Private Company will not issue further shares in satisfaction of the liabilities of the dividend payment The investment in the Private Company is a not an in-house asset and it was held that the Private Company is not a related party of the Fund. Assumptions All dealings and transactions undertaken to give effect to the proposed restructure, together with all ongoing interactions, transactions and business dealings of the entities are conducted 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 Subparagraph 295-550(2) | Income Tax Assessment Act 1997 Subparagraph 295-550(3) | Income Tax Assessment Act 1997 Subsection 995-1(1).

Reasons for decision: Summary: It is considered, based on the facts and assumptions made, that the payment of dividends by the Private Company to the Fund will be consistent with an arm's length dealing. Therefore the dividends paid by the Private Company to Fund 1 will not be considered non-arm's length income of the Fund. In relation to directors' remuneration, the failure to maintain all dealings on an arm's length basis will affect whether the dividends paid to the Fund 1 will be considered non-arm's length income. | Detailed Reasoning - Non-arm's length income: Section 295-545 of the ITAA 1997 provides that the taxable income of a complying superannuation fund is split into a non-arm's length component and a low tax rate 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 deciding whether there has been an arm's length result the factors listed in subsection 295-550(3) are to be considered | Detailed Reasoning - Application of subsection 295-550(3) of the ITAA 1997: 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. | Detailed Reasoning - Paragraphs 295-550(3)(a) and (b): The entity in this case is Fund 1. As a result of the proposed restructure and transactions detailed in the facts, which involve unrelated entities, it will hold no more than X% of the Private Company. The Private Company was established to eventually become a holding company after the proposed restructure and transactions shown in the facts are carried out. Currently, the Private Company is equally held by the Family Trust 1 and Family Trust 2 (the Family Trusts). At the time the Private Company issued its shares, the Family Trusts each paid a nominal amount which reflected the company value as being merely that of a shell company. It is noted that the Private Company will no longer be a shell company when it acquires all the shares in Company X. The price that the Private Company pays for those shares will be at market value and determined by an independent valuer. An estimated market value has been provided. When Fund 1 purchases its shares in the Private Company the price it pays for those shares will be determined by the underlying value of Company X after the Private Company acquired the shares in Company X, the value of which would have been determined by an independent and qualified valuer. The cost of each share will be the market value of the share, which will be the same for the Fund 1 as for the other intended shareholders detailed in the facts. Fund 1's purchase of its shares in the Private Company will be financed by the Fund's existing cash and members' non-concessional contributions. Overall, it is considered that the above factors are favourable to the Commissioner considering the dividends paid to the Fund 1 to be consistent with an arm's length dealing. | Detailed Reasoning - Paragraphs 295-550(3)(c) and (d): There is and will be only one class of shares in the Private Company and all shares will receive the same rate of dividend. Therefore, Fund 1 (as well as the other shareholders) will be entitled to dividends in proportion to its shareholding. The Private Company has not issued any shares in satisfaction of a dividend (or part of it) Further, it has been asserted that all payments in relation to dividends declared will be sourced from cash within the consolidated group. The fact that the rate of any dividend paid to the Fund 1 in respect of the shares it holds in the Private Company will be the same as the rate of dividend paid to the other shareholders would indicate that dividends paid will be consistent with an arm's length dealing. | Detailed Reasoning - Paragraph 295-550(3)(e): As stated in the facts, the private company has not, nor will it, issue any shares in satisfaction of any dividends. Accordingly, this paragraph is not relevant and will be a neutral factor in determining if any dividends paid will be non-arm's length income. Paragraph 295-550(3)(f): The Commissioner considers that a matter is relevant under paragraph 295-550(3)(f) if it indicates whether or not dividends are derived on an arm's length basis and also whether the parties are dealing at arm's length. In this case the following factors have been taken into consideration in addition to those already considered in paragraphs 295-550(3)(a) to 295-550(3)(e): (a) the partners of the Partnership are unrelated. They are under no control or influence of each other. Each partner would consider its own interest during the process to determine how much lease to be charged; (b) the Family Trusts are not connected except in the current business operation in Company X and in the aforementioned partnership; (c) the individual members of each superannuation fund involved are not in business ventures with other and there are no other dealings between the Partnership and any person or entity in either the Family Trust groups; (d) no one party exercises influence over the other parties in relation to the operations of the business; (e) the amendments made to the Private Company and Company X's respective constitutions; (f) all the shares will carry the same rights to capital and income of the private company and have the same rights to cast the vote at the shareholders meetings; (g) the value of the shares in the Private Company which are to be acquired reflect the market value of the Company X business which will be determined by an independent and qualified valuer; and (h) the dealings by the parties in the proposed restructure are in accordance with the facts presented and assumptions made in this Ruling. | Detailed Reasoning - Conclusion: On the whole, having regard to the matters listed in paragraph 295-550(3)(a) to (f) of the ITAA 1997, these factors are favourable for the Commissioner to treat from the dividends paid by the Private Company to Fund 1 as being consistent with an arm's length dealing. Therefore, dividends paid by the Private Company to Fund 1 will not be considered non-arm's length income of Fund 1 as defined by section 295-550 of the ITAA 1997. Notwithstanding the above it should be noted that this position would be jeopardised, and accordingly how the dividends are treated, if any non-commercial or non-market transactions occur in relation to the restructure or any future business transactions.