Private ruling: Non-arms length income of a superannuation fund
Published: April 2013
Ruling period: Income year ending 30 June 2013
Date scheme commenced: During the income year ending 30 June 2013

Ruling: Q1: Will the dividends and attached franking credits received by the a superannuation fund from a private company be non-arm's length income of the fund in accordance with subsection 295-550(3) of the Income Tax Assessment Act 1997 (ITAA 1997)? | A1: Yes Issue 2 | Q2: Will section 177E of the Income Tax Assessment Act 1936 apply to the transaction, and the subsequent payment of dividends? | A2: Unable to rule

Relevant facts and circumstances: Superannuation Fund (the Fund) The Fund is a complying self managed superannuation fund. The only members and trustees of the Fund are Member 1 and their spouse, Member 2. Both members are currently over 60 years of age. Each member holds one share in a private company (the Company). The trustees of the Fund intend to purchase shares in the Company from the members. Subsequently, the members intend to contribute to the Fund some or all of the proceeds from the sale of the shares. Upon transfer of the Company shares to the Fund, the Fund will be the sole shareholder of the Company. Dividends received by the Fund in respect of the Company shares will be used to fund pension payments to the members. The Company The Company was incorporated in the late 1980's. The sole director of the Company is Member 1. The shareholders of the Company are Member 1 and Member 2 who acquired their shares in the late 1980's at a nominal cost per share. Current net worth of the Company is in excess of $2,000,000 and in the late 1980s the net worth was a nominal value. Financial statements for the relevant year show a number of Company loans. These loans will be paid back to the Company in full prior to the acquisition of the Company shares by the Fund. Currently, the Company shares have been valued on a net asset backing basis at in excess of $X per share. All the shares in the Company carry the same rights as to voting, dividends and capital distributions. When the Company sold its business a few years ago, it made a capital gain which was exempt in accordance with section 152-125 of the ITAA 1997. Since the sale of the business, the company has not carried on any further business. The Company will continue to earn income in the form of interest. The dividend amounts that the Company wishes to pay to the Fund will be based on the previous dividends paid by the Company and the pension requirements of the Fund.

Relevant legislative provisions: Income Tax Assessment Act 1936 Section 177E. | Income Tax Assessment Act 1936 Section 273. | Income Tax Assessment Act 1936 Paragraph 273(2. | 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)(f).

Reasons for decision: Summary: The dividend to be paid to the Fund by the private company will be non-arm's length income of the Fund because the dividend would not be derived on an arm's length basis. | Detailed Reasoning - Detailed reasoning: The amounts of ordinary income or statutory income that are non-arm's length income of a complying superannuation fund are set out in section 295-550 of the Income Tax Assessment Act 1997 (ITAA 1997). In particular, subsection 295-550(2) of the ITAA 1997 provides that an amount of ordinary income or statutory income is non-arm's length income of a complying superannuation fund 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. In this case, the Fund is expected to receive a dividend paid by a private company, therefore, paragraph 295-550(2)(a) of the ITAA 1997 will apply to any dividends received by the Fund. In accordance with subsection 295-550(3) of the ITAA 1997, in deciding whether an amount is consistent with an arm's length dealing for the purposes of subsection 295-550(2), regard must be given 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. Thus, to determine whether or not the dividends received by the Fund will be non-arm's length income of the Fund, it is necessary to consider paragraphs 295-550(3)(a) to (e) of the ITAA 1997. A matter will be relevant under paragraph 295-550(3)(f) if it indicates whether or not the dividends are derived on an arm's length basis. The Commissioner of Taxation (the Commissioner) has issued Taxation Ruling TR 2006/7 which explains what amounts are considered to be 'special income' under former section 273 of the Income Tax Assessment Act 1936 (ITAA 1936). 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. The Commissioner will consider paragraphs 295-550(3)(a) to (e) of the ITAA 1997 as matters that indicate whether or not the dividends are derived on an arm's length basis. The Commissioner will consider a matter to be relevant under paragraph 295-550(3)(f) if it indicates whether or not the dividends are derived on an arm's length basis. 1 The matters listed in paragraphs 295-550(3)(a) to (d) of the ITAA 1997 are to be considered in comparison with each other. In cases where the dividend paid relates to a share which has a par value, the Commissioner will compare this value with the partly paid value under paragraph 295-550(3)(a). The cost of the shares considered under paragraph 295-550(3)(b) of the ITAA 1997 will be compared with the market value of the shares at the time of acquisition, which is considered under paragraph 295-550(3)(a). The rate of dividend considered under paragraph 295-550(3)(c) will be compared to the rate of dividend paid on any other shares in the company, which is considered under paragraph 295-550(3)(d). Consideration of matters under subsection 295-550 of the ITAA 1997 | Detailed Reasoning - Value/cost of shares: In this case, the Fund is to acquire all the shares in the Company. Based on the net worth of the Company, the shares are valued at in excess of $X per share and the cost of the shares to the Fund is in excess of $X per share. As such, it is considered, that the shares would be acquired by the Fund at market value. | Detailed Reasoning - Rate of dividend: On acquisition of shares the Fund will be the sole shareholder of the Company so it is not possible to compare the rate of dividend to be paid to the Fund to the rate of dividend to be paid to any other shareholder. However, the fact that all the shares in the Company carry the same rights to dividends would indicate that the dividend would be paid on an arm's length basis. | Detailed Reasoning - Other relevant matters: The Commissioner considers that a matter is relevant under paragraph 295-550(3)(f) of the ITAA 1997 if it indicates whether or not the dividends are derived on an arm's length basis. In Federal Commissioner of Taxation v AXA Asia Pacific Holdings Ltd 2 , Justice Dowsett of the Full Federal Court summarised the cases dealing with the expression 'at arm's length' 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; … Also, in Darrelen Pty Ltd v Federal Commissioner of Taxation 3 , the Full Federal Court held that while former paragraph 273(2)(c) of the ITAA 1936 does not permit reference to the rate of return on the investment, the Commissioner may nonetheless have regard to the rate of return on the investment under former paragraph 273(2)(f) of the ITAA 1936. Based on the above, the matters that may be relevant for the purposes of paragraph 295-550(3)(f) of the ITAA 1997 include: · the extent to which members who are at arm's length to the private company have an interest in the superannuation fund, · the relationship between the superannuation fund, and the private company; · the relationship between the superannuation fund and any party with which the private company has dealings; · who the superannuation fund acquires the shares from and the circumstances of that acquisition; and · the rate of return on the superannuation fund's investment. Taking the above into consideration, it is considered that the payment of dividends by the Company to the Fund would not be consistent with an arm's length dealing. This view is based on the following factors. Member 1 and Member 2 each have a 50% interest in the accumulated benefits in the Fund. Member 2, as Member 1's spouse, is related to Member 1 who, as the director of the Company, is an associate of the Company. As such, there are no members in the Fund who are at arm's length to the Company. As a result, dividends to be paid to the Fund will be entirely for the benefit of Member 1 and Member 2. The Fund's shareholding is equal to 100% of the total shareholding in the Company. As stated above, Member 1 is a trustee of the Fund and the sole director of the Company. Therefore, Member 1 is in a position to exert influence over the affairs of the Company, including the timing and amount of dividend payments. The acquisition of the Company shares from Member 1 and Member 2 (related parties of the Fund) and the subsequent contributions by Member 1 and Member 2 to the Fund, enables Member 1 and Member 2 to divert personal income to a concessionally taxed environment. That is, from Member 1 and Member 2 to the Fund. As the Fund is in pension phase, any income earned will otherwise be exempt from tax in the Fund. Further, because Member 1 and Member 2 are both over 60 years of age, any benefits paid by the Fund to Member 1 and/or Member 2 will otherwise be non-exempt, non-assessable income in the hands of Member 1 and Member 2. Also, by selling the shares to the Fund and then contributing all or part of the proceeds back into the Fund, some or part of Member 1's and Member 2's' taxable component may be converted into a tax-free component with the result that any death benefits paid to their non-dependent beneficiaries, whether directly or via an estate, would be non-assessable, non-exempt income of those beneficiaries. Finally, while the amount of the dividend is not specified and the rate of return on the Fund's investment is not known, it is stated that the amount of dividends to be paid by the Company will be based, in part, on the pension requirements of the Fund. However, when deciding whether or not to pay a dividend and the amount of dividend to pay, directors of a company are required to consider whether: (a) the company's assets exceed its liabilities immediately before the dividend is declared and the excess is sufficient for payment of the dividend; and (b) the payment of the dividend is fair and reasonable to the company's shareholders as a whole; and (c) the payment of the dividend does not materially prejudice the company's ability to pay its creditors. Based on the above, the fact that the dividends to be paid to the Fund will depend, in part, on the Fund's pension requirements, would suggest that the intention of the parties (ie, the Company, the Fund and Member 1 and Member 2) is to serve a common interest and in doing so modify the terms on which strangers would otherwise deal. | Summary: The private ruling application for the Fund is not valid with respect to the question on the application of section 177E of the ITAA 1936. | Detailed Reasoning - Detailed reasoning: A private ruling is a written expression of the Commissioner's opinion of the way in which a relevant provision applies, or would apply, to the entity whose tax affairs are the subject of the ruling, in relation to the specified arrangement. If section 177E of the ITAA 1936 is found to apply to an arrangement, it operates to treat the original shareholders of a company as if they had received an assessable dividend from the company. Therefore, in the present case, the tax affairs that may be affected are those of the Company's current shareholders, that is, Member 1 and Member 2, rather than the Fund. Consequently, a private ruling with regards to section 177E of the ITAA 1936 can only be provided to Member 1 and Member 2. That is, the private ruling application for the Fund is not valid with respect to the question on the application of section 177E of the ITAA 1936. If a private ruling is still required on the application of section 177E of the ITAA 1936, a private ruling application on behalf of Member 1 and Member 2 should be lodged. 1 See TR 2006/7, paragraph 18. 2 [2010] FCAFC 134; (2010) 189 FCR 204; (2010) 2010 ATC 20-224; [2011] ALMD 2345; (2010) 81 ATR 180. 3 [2010] FCAFC 35; (2010) 2010 ATC 20-180; (2010) 183 FCR 237; [2010] ALMD 4701; (2010) 78 ATR 916.