Private ruling: Non-arm's length income
Date of advice: 30 July 2015
Published: July 2015
Ruling period: Income year ended 30 June 2014
Date scheme commenced: 1 July 2013

Ruling: Q1: Will dividends paid by a private company (the Company) to a self-managed superannuation fund (the Fund) be non-arm's length income of the Fund under section 295-550 of the Income Tax Assessment Act 1997 ? | A1: Yes.

Relevant facts and circumstances: The Fund is a self-managed superannuation fund which was established during the 2007-08 income year. There are two members in the Fund - Member 1 and Member 2. The trustee of the Fund (the Trustee) is a company. Directors and members of the Trustee are Member 1 and Member 2. The Trustee holds one of the four ordinary shares in the Company. The Company was established during the 20WW-XX income year by issuing a number of shares. The Company then borrowed, as shown in a loan agreement, an amount from a non-related trust (the Trust) to acquire a business. The interest rate on the loan was set to a retail bank variable home loan rate. The trust which provided the loan to the Company is a discretionary trust with a corporate beneficiary. Member 2 is the primary beneficiary, and Member 1 is also a beneficiary. The price the Trustee paid for the Company share is $. At the time of the purchase of the share, the Company had no assets as the business value was equal to its debt. The director of the Company is not related to the Fund or Member 1 and Member 2 in any capacity. In the 20XX-YY income year, the Company declared a dividend and paid % of the total dividend to the Fund. No shares were issued by the Company in satisfaction of any dividends. The Company does not expect to pay a dividend in the 20YY-ZZ income year.

Relevant legislative provisions: Income Tax Assessment Act 1936 Former section 273 | Income Tax Assessment Act 1997 Section 295-550 All legislative references are to the ITAA 1997 unless otherwise indicated.

Reasons for decision: Summary: The Commissioner is of the opinion that the transactions involving the payment of dividends by the Company to the Fund will produce a non-arm's length outcome. Therefore, the dividends paid by the Company to the Fund will not be considered to be non-arm's length income of the Fund. | 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 accordance with subsection 295-550(3), 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. 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. At paragraphs 19 and 20 of TR 2006/7, the Commissioner states: 19. Dividends are only derived on an arm's length basis when the shares are acquired, the investment is maintained, and the dividends are paid on an arm's length basis. If the shares are acquired at market value, the private company is not involved in non-arm's length dealings and the rate of dividend is the same as the rate of dividend paid on other shares in the company or is reasonable having regard to investment risk, and there are no other matters that the Commissioner will consider relevant, the Commissioner will form the opinion that it would be reasonable not to treat the dividend as special income. 20. The Commissioner will consider the matters listed in paragraph 273(2)(a) to (d) 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 273(2)(a). The cost of the shares considered under paragraph 273(2)(b) will be compared with the market value of the shares at the time of acquisition, which is considered under paragraph 273(2)(a). The rate of dividend considered under paragraph 273(2)(c) will be compared to the rate of dividend paid on any other shares in the company, which is considered under paragraph 273(2)(d). In applying subsection 295-550(2) to the facts of this case, the Commissioner will consider paragraphs 295-550(3)(a) to (e) 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) if it indicates whether or not the dividends are derived on an arm's length basis. The facts of the case and all the matters contained in paragraphs 295-550(3)(a) to (f) cannot be considered in isolation to each other but must be considered as a whole. | Detailed Reasoning - Paragraphs 295-550(3)(a) and (b): At the time the Company issued its shares, the Company had no assets. That being the case, the market value of the shares is nil. However, the price that the Fund and the other shareholder paid for the Company shares was $ per share. Although, on face value, the price paid by the Fund for the Company share was above the market value of Company shares, the fact that the Fund paid the same price as the other shareholder who originally subscribed for shares indicates that the share was acquired at market value. It is considered these circumstances would not support a finding of 'non-arm's length income'. | Detailed Reasoning - Paragraphs 295-550(3)(c) to (e): There is only one class of shares and all the shares in the Company have received the same rate of dividend. The Fund (as well as the other shareholder) is entitled to dividend 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 paid to the Fund in respect of the share it holds in the Company is the same as the rate of dividend paid to the other shareholder would indicate that the dividend is paid on an arm's length basis. | Detailed Reasoning - 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 the dividends are derived on an arm's length basis. 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 circumstances. 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; • however related parties may, in some circumstances, so conduct a dealing as to displace any inference based on the relationship; • 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. The parties in this case can be considered to be in an arm's length relationship in regards to the dividends paid by the Company. This is because: • Member 1 and Member 2 are not involved in the operation of the Company; • the Fund and the other shareholder of the Company are not related; and • there is nothing to indicate that members of the Fund may influence, or are in a position to significantly affect, the decisions of the Company, including the timing and amount of the payment of dividend. However, it is also necessary to consider whether the parties have dealt with each other as arm's length parties would do, so that the outcome of their dealing is a matter of real bargaining. At paragraph 78 of TR 2006/7, the Commissioner states that parties that are at arm's length can deal with each other in a way that is not at arm's length. As Dowsett J mentioned in AXA, 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 [of] 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' … Assessing the circumstances holistically, the Commissioner considers that the parties, in this case, are not dealing with each other in relation to the dividend as arm's length parties would do. Aspects which, taken together, the Commissioner considers lead to that conclusion include: • The loan made to the Company (the Loan) is 100% of the purchase price of the business. Generally, the loan to value ratio (LVR) is used by a lender to limit the lender's loss in the event that a borrower defaults. High LVR loans are generally provided where the risk of default and loss are smaller while low LVR loans are provided where the risk of default and loss are greater. To help mitigate the risk associated with high LVR, lenders will generally require additional terms such as mortgage insurance or an upfront risk fee. In this case there is no mortgage insurance or upfront risk fee mentioned in respect of the loan. • The Loan interest rate is set with reference to a retail bank standard variable home loan rate. However, in this case the loan is not over residential property but over a business which is a more volatile asset and therefore, a greater risk than property. To mitigate the risk, an arm's length lender would charge a higher interest rate to reflect the nature of the asset borrowed against. • Banks commonly require personal guarantees for loans that have a standard LVR, let alone a 100% LVR. Therefore, in the circumstances, an arm's length lender would still require additional security such as mortgage insurance or actual security over a separate asset that they could have recourse to in case of default. In this case no personal guarantee was sought from Company directors. • In Darrelen Pty Ltd, Trustee of the Henfam Superannuation Fund v FCT [2010] FCAFC 35; (2010) 2010 ATC 20-180, 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 - the immediate predecessor of paragraph 295-550(3)(f). • In this case, the Fund has received a dividend at the rate of X%. Although the same rate of dividend is paid to the Fund and the other shareholder of the Company, a dividend rate of X% is considered to be overly excessive relative to the amount paid for the shares. If the parties in this case were dealing with each other at arm's length, the amount of ordinary or statutory income the Fund might be expected to derive as a dividend on the Company share is nil. It might be expected that an arm's length lender would not lend any capital to the Company for the acquisition of the business on the loan terms that form part of the scheme under which the dividend is derived. Without the loan it might be expected that the Company would not acquire the business and consequently, would not realise the profits from which the dividends are paid and so no ordinary or statutory income might be expected to be derived by the Fund as a shareholder of the Company. Based on the above, the Commissioner considers that the dividend received by the Fund from the Company is non-arm's length income of the Fund.