Private ruling: Non-arm's length income
Published: April 2013
Ruling period: Year ending 30 June 2013.
Date scheme commenced: During the income year ending 30 June 2013

Ruling: Q1: Will dividends to be paid by a private company in the 2012-13 income year to the Superannuation Fund be considered non-arm's length income of the fund in accordance with section 295-550 of the Income Tax Assessment Act 1997 ? | A1: Yes

Relevant facts and circumstances: The Superannuation Fund (the Fund) The Fund is a complying self managed superannuation fund. The members and trustees of the Fund are Member 1 and Member 2. Member 1 and Member 2 are both over 60 years of age. A few years ago, the Fund commenced paying pensions. No contributions were made into the Fund in subsequent years. During the 2011-12 income year the Fund has acquired a number of Ordinary shares in a private company (The Company) for a nominal value per share. The current value of the shares remains the same. The Company The Company was incorporated less than five years ago. Directors of the Company are Member 1 and Person A. The Company has issued a number of Ordinary class shares at a nominal value per share. All the shares in the Company have been fully paid. The shareholders of the Company are: (a) Member 1 and Member 2 as the trustees for The Fund - holding 50% of the Ordinary shares; and (b) Company B as the trustee for the A Family Superannuation Fund - holding 50% of the Ordinary shares. The director and shareholder of Company B is Person A. The only member of the A Family Superannuation Fund is Person A. Person A is over 60 years of age. The Company holds units in a unit trust (the Unit Trust). The Company does not carry on any business activities other than to hold units in the Unit Trust. Only paid up capital is present. Directors of the Company are to be remunerated as/when commissions/profits are received by the Company from its unit holding in the Unit Trust. It is anticipated that during the 2012-13 income year, the Company will pay a dividend of more than $500,000 to each shareholder in accordance with their shareholding. No dividends have been previously paid by the Company. It is proposed that dividends will be paid once the Company receives a distribution from the Unit Trust. The Company will pay the same rate of dividend to both shareholders. No shares were issued by the Company in satisfaction of the dividends. The Unit Trust The Unit Trust was created several months after the Company. The trustee of the Unit Trust is Company C (the Unit Trust Trustee). Unit holders of the Unit Trust are: (a) the Company; and (b) Company D as the trustee for the E Family Trust. The director and shareholder of Company D is Person E. The Company was allotted a number of Ordinary Units and at a nominal value per unit. The Unit Trust Trustee does not hold any assets on behalf of the Unit Trust. The arrangement between the parties involved in the creation of the Unit Trust was that Person E would, through corporate entities, provide the funding and Person A would provide expertise, contacts and knowledge. Initially, some funding for the establishment of the Unit Trust was provided by Company D. Subsequently, Company F, on behalf of the Unit Trust Trustee, agreed to provide 'further funding' which comprised 'advances' to the sum of several million dollars. The director and shareholder of Company F is Person E. Subsequently, the Unit Trust Trustee issued several Special Units - a number to the Private Company and an identical number to Company D. Later, a further identical number Special Units were issued to Company D. The cost of the Special Units at issue was nominal value per unit. The Company currently holds a certain number of Ordinary Units and a smaller number of Special Units. Company D currently holds a smaller number of Ordinary Units and a larger number of Special Units. The holders of Special Units are entitled to the net amount of income and capital of the Unit Trust derived from any investments or transactions relating to Overseas Company G and Overseas Company H or any entity associated with those companies. The Unit Trust has no borrowings. The Unit Trust does not intend to trade but to earn or share commissions earned from introducing buyers and sellers of certain commodities. Current value of Ordinary Units is the nominal value per unit. Current value of Special Units is the nominal value per unit. The trust deed (the Deed) of the Unit Trust provides that: § The trustee can issue additional units at any time; § The trustee may redefine 'income of the trust' in any financial year at the trustee's absolute discretion; § The trustee has absolute discretion in determining whether any receipt, gain, payment profit, loss, outgoing, money or investment in respect of any accounting period shall be treated as income or capital of the trust; § Any income of a financial year, and any capital accumulated or distributed may be determined by the trustee to constitute all or part of a category of income or capital; § Whether any income of the trust fund, or part of, is accumulated rather than distributed shall be at the absolute discretion of the trustee; § No person, including any unit holder, shall be permitted to challenge the trustee's exercise or failure to exercise a discretion or power; § If the trustee has a discretion to do something that discretion shall include an absolute discretion as to whether or not to do that thing; and § The trustee may at any time vary any condition or term of the Deed (except the one dealing with the removal/appointment of a trustee); The Unit Trustee As noted earlier, the trustee of the Unit Trust is Company C. The Unit Trustee undertakes no activities other than act as trustee for the Unit Trust. Directors and the shareholders of the Unit Trustee are Member 1, Person A and Person E. The Unit Trustee is engaged in business association with Overseas Company G and Overseas Company H (the Trading Entity) who are a commodities trading entity. The Unit Trustee is to receive commissions or other benefits from transactions entered into with the Trading Entity.

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 Subsection 295-550(2). | Income Tax Assessment Act 1997 Subsection 295-550(3). | Income Tax Assessment Act 1997 Paragraph 295-550(3)(f). | Income Tax Assessment Act 1936 Section 273. | Income Tax Assessment Act 1936 Paragraph 273(2)(f).

Reasons for decision: Summary: The dividend to be paid to the Fund by a private company will be non-arm's length income of the Fund because it would not be consistent with an arm's length dealing. | 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. (See TR 2006/7, paragraph 18) 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). | Detailed Reasoning - Value/cost of shares: The Company shares that are assets of the Fund were acquired for a nominal value per share. The price paid for the shares by the other shareholder of the Company is also the same nominal value per share. At the time of acquisition, the Company: § issued a small number of shares in total; § did not undertake any business activities; and § did not have any assets other than the units held in the Unit Trust. Although, on face value, the price paid for the shares appears to be above the market value of shares, the fact that the Fund paid the same price as the other shareholder who originally subscribed for shares indicates that the shares were acquired at market value. | Detailed Reasoning - Rate of dividend: The Company expects to pay a dividend at the rate of more than 1,000%. It is stated that all the shares in the Company have equal rights to dividends, and the Fund (as well as the other shareholder) is entitled to dividends in proportion to its shareholding. The Company has not issued any shares in satisfaction of a dividend (or part of it). The fact that the rate of dividend to be paid to the Fund in respect of the shares it holds in the Company is the same as the rate of dividend to be paid to the other shareholder would indicate that the dividend is 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 ([2010] FCAFC 134; (2010) 189 FCR 204; (2010) 2010 ATC 20-224; [2011] ALMD 2345; (2010) 81 ATR 180) 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, Trustee of the Henfam Superannuation Fund v FCT ([2010] FCAFC 35; (2010) 2010 ATC 20-180; (2010) 183 FCR 237; [2010] ALMD 4701; (2010) 78 ATR 916) 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 one of the directors 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 the Members. The Fund's shareholding is equal to 50% of the total shareholding in the Company. As stated above, Member 1 is a trustee of the Fund and one of two directors of the Company. Therefore, Member 1 is in a position to exert sufficient influence over the affairs of the Company, including the timing and amount of dividend payments. Member 1 is a member and trustee of the Fund and a director and shareholder of the trustee of the Unit Trust. As a director of the trustee of the Unit Trust, Member 1 may be in a position to significantly influence allocations from the Unit Trust to the Company. The dividends to be paid to the Fund are attributable to the allocations from the Unit Trust to the Company. The Company, the Unit Trust and the Unit Trust Trustee were established within a short time of each other. The Fund acquired the shares from the Company at/about the time the Company was established. The income is to be generated in the Unit Trust; the Unit Trust is to make an allocation to the Company; and from the allocations received, the Company is to pay dividends to the Fund. Thus, dividends to be paid to the Fund are attributable to allocations from the Unit Trust. That is, the Fund derives income indirectly from the Unit Trust. Based on the terms of the trust deed of the Unit Trust set out in the facts above, the beneficiaries of the Unit Trust do not have a fixed entitlement to the income of the Unit Trust. Therefore, if the Fund was to receive an allocation from the Unit Trust directly (rather than as a dividend from the Company), the amount received would be non-arm's length income of the Fund in accordance with subsection 295-550(4) of the ITAA 1997 and taxed at 45%. The creation and structuring of the relevant entities enables parties associated with them (Member 1, Person A and Person E ) to divert income to a concessionally taxed environment. That is, from the Unit Trust to the Company and then, in the case of Member 1 who is over age 60, to the Fund and, in the case of Person A, who is also over age 60, the A Family Superannuation 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. Although the same level of dividends are to be paid to the Fund and the other shareholder of the Company, a dividend rate of more than 1,000% is considered to be overly excessive relative to the nominal amount paid for the shares. Therefore, dividends to be paid by the Company to the Fund will be non-arm's length income of the Fund.