Private ruling: Non-arm's length income of a superannuation fund
Published: May 2016
Ruling period: Year ending 30 June 2017
Date scheme commenced: 1 July 2016

Ruling: Questions and Answers | Will the dividends received by the Fund from a newly established private company (the Company) be non-arm's length income of the Fund under section 295-550 of the Income Tax Assessment Act 1997 (ITAA 1997)? | Yes

Relevant facts and circumstances: This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling. The Fund 1. Company A is the trustee of the Fund. The Fund is a complying self-managed superannuation fund that was established in 20XX. The current members of the Fund are Person A and their spouse, Person B. The directors and shareholders of Company A are Person A and Person B. 2. Person A and Person B are currently in their 40's. The Family Trust 3. Company B is the trustee of the Family Trust. The directors and shareholders of Company B are Person A and Person B. The Family Trust is a discretionary trust. 4. The Family Trust commenced operating in 20XX. The Family Trust holds XX% of the units in a Unit Trust. An unrelated entity holds the other YY% of the units in the Unit Trust. The Unit Trust is undertaking a property development. Once the property development is completed the Unit Trust will be closed and distributions will be made to the Family Trust. 5. The beneficiaries of the Family Trust are defined as: a. The Primary Beneficiary and the Children, Brothers, Sisters, parents, uncles, aunts, grandparents, great uncles and great aunts of the Primary Beneficiary. b. The Spouse, Children and remoter lineal descendants of all of the persons described in a. c. Any Corporation in which: i. A share is beneficially held by or any directorship is held by any of the persons included as beneficiaries; or ii. The Trustee is a shareholder. a. Any Trust (including, without limitation, any discretionary, unit, fixed or hybrid, deceased estate, superannuation fund or testamentary trust) from which any of the persons (including Corporations) described as beneficiaries can benefit, whether or not any other person is capable of receiving a benefit from the trust. b. ………... 6. The main beneficiaries of the Family Trust are: • Person A, • Person B, and • Their children 7. It is intended to implement the following steps: (a) Company A as trustee of the Fund will be the sole shareholder of a private company (the Company). The Company is yet to be established. (b) The Fund will purchase the 12 issued shares in the Company for $1 per share at the establishment of the Company. The Fund will pay for the shares using cash from the Fund's bank account. The Fund will transfer the $12 for the purchase of the shares into the Company's bank account upon commencement. (c) The directors of the Company will be Person A and Person B. (d) The directors will pay for the establishment of the Company with their own funds. (e) The Company will be made a beneficiary of the Family Trust. (f) When the Family Trust receives a distribution in respect of its holding of units in the Unit Trust, the Family Trust will make distributions of income to the Company as a beneficiary. (g) The Company, upon receipt of the distributions from the Family Trust, will invest the money in property and other investments. The Company will commence a property development business. The Company will not borrow money, as one concern is to not breach the "in-house asset" rules. In future years, after profits are generated from operating the business in the Company, consideration would be given to declaring a dividend. (h) It is estimated that the Company will pay dividends to the Fund (being the only shareholder) of $10,000 to $15,000 per annum. (i) The dividends will be fully franked. (j) Person A's and Person B' long term plan is to keep the Company trading in property development with the possibility of allowing their children to assist in this family business.

Relevant legislative provisions: Income Tax Assessment Act 1936 section 273 | Income Tax Assessment Act 1936 paragraph 273(7)(a) | Income Tax Assessment Act 1997 section 295-545 | Income Tax Assessment Act 1997 subsection 295-545(1) | Income Tax Assessment Act 1997 subsection 295-545(2) | Income Tax Assessment Act 1997 section 295-550 | 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)(a) | Income Tax Assessment Act 1997 paragraph 295-550(3)(c) | Income Tax Assessment Act 1997 paragraph 295-550(3)(d) | Income Tax Assessment Act 1997 paragraph 295-550(3)(f) | Income Tax Assessment Act 1997 subsection 995-1(1)

Reasons for decision: Summary: 8. Leaving aside considerations of Part IVA of the ITAA 1936, the franked dividends and attached franking credits from the Company to the Fund would be non-arm's length income of the Fund under subsection 295-550(2) of the ITAA 1997. The franked dividends and attached franking credits would therefore be subject to income tax at the highest individual marginal tax rate (47% for the income year ending 30 June 2017 including the temporary budget repair levy). | Detailed Reasoning - Detailed reasoning: 9. In accordance with section 295-545 of the ITAA 1997 the income of a complying superannuation fund is split into a 'non-arm's length component' and a 'low tax component'. 10. The note to subsection 295-545(1) of the ITAA 1997 explains that a concessional rate (15%) of tax applies to the low tax component, while the non-arm's length component is taxed at the highest marginal tax rate. 11. Subsection 295-545(2) of the ITAA 1997 provides that the non-arm's length component for an income year is the entity's non-arm's length income for that year less any deductions to the extent that they are attributable to that income. The phrase 'non-arm's length income' has the meaning given by section 295-550 of the ITAA 1997. 12. The Commissioner has issued Taxation Ruling TR 2006/7 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 former section 273 of the ITAA 1936 which concerned 'special income' (now termed non-arm's length income) and continues to provide the ATO view so far as the new provision (section 295-550 of the ITAA 1997) expresses the same ideas as section 273. 13. Dividends paid to an entity by a private company, along with ordinary or statutory income reasonably attributable to such a dividend (such as the franking credits), are non-arm's length income of the entity unless the amount is consistent with an arm's length dealing (subsection 295-550(2) of the ITAA 1997). 14. Subsection 295-550(3) of the ITAA 1997 requires consideration of the following matters when deciding whether an amount is consistent with an arm's length dealing: (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. 15. In the facts of this case the shares in the Company are to be purchased at the value of $12 and reflected at that value in the members' accounts. Given the understanding that the Company is to become a beneficiary of the Family Trust and will receive a discretionary distribution from it for no valuable consideration the market value of the shares may not be $12. This is a relevant consideration under paragraph 295-550(3)(a) of the ITAA 1997 and the acquisition of shares at a cost of less than market value is not consistent with an arm's length dealing. 16. The rate of the dividend (paragraph 295-550(3)(c) of the ITAA 1997) is also relevant and refers to the amount of the dividend (or dividends) paid per share over a period of time (e.g. annually) by a company. In this case the dividend rate reflects the annual distributable profits of the Company. 17. As the Fund is the only shareholder there is no comparison to be made as between the rate of dividends paid to the Fund and the rate of dividends paid to any other shareholder (paragraph 295-550(3)(d) of the ITAA 1997). 18. Other relevant factors (paragraph 295-550(3)(f) of the ITAA 1997) to consider in determining whether a dividend, or an amount attributable to a dividend, is consistent with an arm's length dealing include the market value of the shares as compared with the dividend rate; the rate of return on investment; and the level of investment risk undertaken by the Fund in relation to the dividend rate and the rate of return. In addition, other relevant factors to consider include the derivation of the profits of the Company and whether there have been any non-arm's length dealings or transactions resulting in the profits or capital available to the Company being greater than if all dealings and transactions were conducted on an arm's length basis. Whether parties are not dealing with each other at arm's length 19. In determining whether the parties deal at arm's length it is necessary to consider any connection between them and any other relevant circumstances (see the meaning of 'arm's length' in subsection 995-1(1) of the ITAA 1997). 20. It is clear that the parties in the present case are not at arm's length. Person A and Person B are the directors of the Company, the directors of Company B as trustee of the Family Trust, the directors of Company A as the trustee of the Fund and members of the Fund 21. As to whether or not they are dealing at arm's length, in Federal Commissioner of Taxation v. AXA Asia Pacific Holdings Ltd [2010] FCAFC 134 ( Axa ) Dowsett J (at [26]) summarised propositions, which emerge from the numerous cases in which the expression 'not dealing with each other at arm's length' (or similar) have been considered, 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; • un-related 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. 22. Although Dowsett J dissented in the application of those propositions in that case, Edmonds and Gordon JJ did not disapprove of his summary of those propositions. 23. In that case Edmonds and Gordon JJ further stated 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':.. 24. Further, the Full Court of the Federal Court in Allen held that former paragraph 273(7)(a) of the ITAA 1936 - the immediate predecessor of paragraph 295-550(5)(a) of the ITAA 1997 - does not require that the 'dealing' consist only of the actual derivation of the income in question by 'the entity' but that the evident legislative intention of the provisions is to permit regard to be had to the totality of the steps that result in the entity's acquisition of its fixed entitlement to the income of the trust and any derivation of income by the entity through holding that entitlement. 25. In this case, it is consistent with Allen to consider the arrangement holistically to determine if income of the Fund being the dividend income and the attached franking credits is non-arm's length income. 26. Considering the arrangement holistically, including the other relevant factors outlined in paragraph 18 above, the Commissioner's view is that the dividend income of the Fund is non-arm's length income. The Commissioner has considered the following in the context of the arrangement as a whole in forming this view. • The Fund has minimal investment risk limited to the $12 investment for the subscription for the shares and in return receives dividends of an estimated $10,000 to $15,000 per annum. The price paid for the shares and the investment risk borne by the Fund is disproportionate to the amount of dividends received. • The initial money for the operation of the Company's business activities is provided to the Company as a distribution by a discretionary trust which is a non-arm's length dealing. The Company only receives the discretionary distribution because of the non-arm's length relationship with the trustee of the Family Trust, being Company B that is controlled by Person A and Person B. The Company does not provide any valuable consideration for the distribution from the Family Trust. • The income of the Company has increased as a result of the distribution by the Family Trust. As a result the Company has more income available to be paid as dividends. • If the parties were dealing at arm's length, no distribution from the Family Trust to the Company would be expected and therefore the Company would be limited to the income derived from the $12 received for the subscription of the shares. • The dividends received by the Fund are therefore also an inflated distribution for which it has provided no valuable consideration. 27. Therefore, subsection 295-550(2) of the ITAA 1997 would apply to the Fund with respect to its receipt of the franked dividends and franking credits from the Company. All of the franked dividends and attached franking credits received by the Fund would be subject to tax at the highest individual marginal tax rate. | Detailed Reasoning - MATTERS WE HAVE NOT RULED ON: We have not ruled on all of your questions. Here, we list each question that we have not been able to rule on, and explain why. Will Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936) apply to the arrangement? Given the answer to whether the dividends would be non-arm's length income of the Fund it is not necessary to answer this question as we would apply the more specific provision. 1. Section 359-35 of Schedule 1 to the Taxation Administration Act 1953 provides, by subsection (1), that "[t]he Commissioner must comply with an application for a *private ruling and make the ruling. However, this obligation is subject to subsections (2) and (3)." Subsection (2) provides that: The Commissioner may decline to make a *private ruling if: (a) the Commissioner considers that making the ruling would prejudice or unduly restrict the administration of a *taxation law; or (b) the matter sought to be ruled on is already being, or has been, considered by the Commissioner for you. 2. One of your questions concerned the operation of Part IVA of the Income Tax Assessment Act 1936 . That Part, which deals with tax avoidance, requires careful consideration based on a secure understanding of the relevant facts for it to be applied properly, because its operation may depend on inferences to be made from facts involving matters of impression and questions of degree. This in turn requires confidence in the accuracy and completeness of the account of facts propounded by the applicant. In the case of a transaction yet to be implemented this requires that the applicant is in a position to propound the facts to the required standard of accuracy - facts yet to occur. This is not to suggest that there is any absence of confidence in the honesty or diligence of the applicant or his representatives. Simply, the Commissioner must be confident that he is in a position to answer the question asked of him. He must not guess. 3. An incorrect favourable ruling will immediately prejudice or unduly restrict the administration of a taxation law in regard to the transactions in question, and may embarrass the Commissioner in regard to similar transactions not directly protected by the ruling. An incorrect unfavourable ruling will also tend to prejudice the administration of a taxation law in a different way, by putting the applicant to the unnecessary cost of objecting against the rulings, and seeking review or appealing against any resultant objection decisions, and, further, by detracting from confidence in the administration of the law. 4. As to the significance of nuances of fact required to properly and satisfactorily consider and apply Part IVA, our concern can be sensibly analysed in terms of whether there could be a "matter" within the meaning of section 75 or section 76 of the Constitution of the Commonwealth of Australia . An unfavourable ruling may ultimately give rise to a right to appeal to the Federal Court of Australia; that is, an 'appeal' may be available against an unfavourable objection decision against that private ruling. However, any such right must be consistent with the requirements of the Constitution: it must not be an academic exercise. As the decision of the Court will determine rights, there must be sufficient confidence in the propounded facts to ensure that the decision will determine rights, as opposed to not affecting anything. Indubitably, the circumstances must not be hypothetical. 5. It follows from the above that there must be sufficient confidence that the proposal upon which any ruling is given will occur such that the ruling has effect. And, for the same reason, there must be sufficient confidence that the facts are stated to a standard of accuracy and completeness that a decision will not, whether by reason of misdescription or unjustifiable inference or otherwise, fail to apply to the transaction as it occurs. 6. In the case of a provision such as Part IVA, including sections 177C, 177E and 177F, whose operation will depend on characterisation of facts, the identification of purposes, and matters and impression and degree (and are thus susceptible to a changed answer on a small distinction), and rulings upon which may have a substantial effect on the revenue, it is practically necessary to meet a high standard for a ruling to be given with the required level of confidence. Needless to say, this is particularly important in the context of a provision such as Part IVA. Further, the difficulty is exacerbated in circumstances where the scheme has not yet been carried out. In obiter, their Honours Hill, Sundberg and Goldberg JJ commented in Bellinz and Others v Commissioner of Taxation (1998) 84 FCR 154 that: "While there is nothing to suggest that in an appropriate case a ruling could not issue on Pt IVA of the Act, both the Commissioner and the taxpayer must be aware of the difficulty which a private ruling on a Pt IVA issue will create. … Where the arrangement in respect of which a private ruling is sought has not yet been carried out, it is difficult to see how there could be adequate facts upon which to base a private ruling. …" 7. In this present instance, given the response in this ruling we are of the view that if we answered your Part IVA question we would lack confidence that we had correctly answered it, regardless of whether we answered yes or no. We would in effect be guessing. It is our opinion that the applicant has not settled and indeed cannot settle with sufficient certainty or accuracy the precise train of events upon which in fact the law will operate. | Detailed Reasoning - Review rights when we have declined to make a ruling: We have declined to make your private ruling, and have given you the reasons. If you want our decision to decline to rule reviewed, you may apply to the Federal Court or the Federal Magistrates Court under the Administrative Decision (Judicial Review) Act 1977 . If you choose to apply, we suggest you seek professional advice about how to proceed. The Court will be able to provide you with some direction and assistance with the process. Your appeal may involve a number of fees. An application must be lodged within 28 days of the issue date on your notice of private ruling. You may lodge your application for review at the Federal Court or Federal Magistrates Court in the State or Territory in which you ordinarily reside, or the State or Territory listed in the address for the Australian Taxation Office shown on your Notice of private ruling . You can find more information on the Federal court website: www.fedcourt.gov.au