Private ruling: Non arm's length income
Published: November 2011
Ruling period: 1 July 2009 to 30 June 2012
Date scheme commenced: 1 July 2009

Ruling: Q1: Are dividends on cancelled shares paid to a self managed superannuation fund (SMSF) non-arm's length income of the SMSF?. | A1: No.

Relevant facts and circumstances: The Superannuation Fund (the Fund) is a self managed superannuation fund (SMSF). The members and trustees of the Fund are your client and your client's spouse. Your client occupies a managerial position in a private company (the Company). The Company is a private company with over 500 employees. The issued capital of the Company in the 2010-11 income year consisted of A class shares and ordinary shares. The Company established an employee share plan (ESP). A private company (ESP P/L) was established to conduct the ESP. Ordinary shares in the Company are acquired for the benefit of participating employees of the Company. The participating employees then acquire shares in ESP P/L. There are currently over 25 participating employees occupying various managerial positions. Employees are selected by the Board to participate in the ESP whereby the employee is issued shares in ESP P/L (ESP shares). The employee pays a nominal amount for each ESP share issued. On commencement of employment, your client was invited to participate in the ESP and, in accordance with the ESP's plan rules, your client nominated the Fund as the entity to participate. Therefore, the Fund acquired shares in ESP P/L. The ESP shares are issued to employees with a right to a specified number of shares in the Company. In the case of the Fund the shares were to be held by ESP P/L in an account for the Fund. The ESP P/L shares are informally stapled to the Company shares held by ESP P/L, and so are always valued at and paid up identically to each other. The shares in the Company are acquired by ESP P/L. A commensurate number of ESP P/L shares are then allocated to the participating employee paid to a nominal amount per share. The market value of the shares in the Company is determined annually under the plan based on an objective formula. Dividends are paid equally per share, regardless of whether the share is fully paid or not. If the Company declares a dividend of $2 per share, $2 is paid on fully paid up shares and $2 is also paid on shares partially paid up, including employee shares held by ESP P/L and paid up to a nominal amount. Dividends declared on ordinary shares in the Company held by ESP P/L are applied in paying the unpaid amount of the Company shares it holds. The shares in the Company issued to ESP P/L are ordinary shares and have the same rights as all other ordinary shares in the Company. There are two other shareholders in the Company and their shares were fully paid on issue. The dividend policy of the Company is such that an annual dividend equal to 50% of the after tax profits of the previous year are distributed as a fully franked dividend. Since the Fund acquired the shares the Company has paid fully franked dividends on ordinary class shares. The total of the dividends has been received by ESP P/L and applied to pay in part the unpaid amount on the shares held in the Company. Once the Company shares held in respect of an employee participant by ESP P/L are fully paid then dividends paid by the Company on such shares are received by ESP P/L and then paid to its shareholders. Cash dividends received by the holder of the ESP shares are fully franked and are included in the taxable income of the shareholder in the income year in which the dividend is paid by ESP P/L. On termination of employment of an employee participant, the following occurs: (a) The Company shares held by ESP P/L in respect of the employee are bought back by the Company at the market value of the Company shares for that year of income using the formula mentioned above. The consideration for the share buy-back by the Company is paid partly out of the share capital account of the Company (to the extent that the shares have been paid) and partly out of the retained profit of the Company. (b) The ESP shares held by the participating employee or the employee's nominee are cancelled pursuant to the Constitution of ESP P/L and the ESP Rules. The amount received by the holder of the ESP plan shares is an amount credited by ESP P/L out of its retained profits and accordingly is treated by ESP P/L as a fully franked dividend. The amount received by the holder of the ESP P/L shares is calculated as follows: (a) An amount equal to the value at the time of termination of the Company shares held by ESP P/L in respect of the employee concerned; less (b) The amount unpaid at the time of the termination on the Company shares held by ESP P/L in respect of the employee concerned. Accordingly, the Fund holding ESP P/L shares under the Plan will be entitled to receive: (a) Fully franked dividends during the course of the Fund's participation in the Plan where the Company shares are fully paid; and (b) A lump sum amount as a fully franked dividend on termination of employment of the taxpayer. The majority of members on the Company Board are entitled to participate in the ESP Plan. The Board members of ESP P/L includes your client. The Company is audited by an accounting firm. ESP P/L is not audited but has its accounts prepared by an independent firm of accountants. The calculation of the market value of the Company shares and the dividends paid by ESP P/L is reviewed by the accounting firm. It is not yet known when your client will be terminating employment with the Company.

Relevant legislative provisions: Income Tax Assessment Act 1936 Subsection 273(2). | Income Tax Assessment Act 1997 Section 295-545. | 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)(a). | Income Tax Assessment Act 1997 Paragraph 295-550(3)(b). | 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)(e). | Income Tax Assessment Act 1997 Paragraph 295-550(3)(f). | Income Tax Assessment Act 1997 Subsection 295-550(4). | Income Tax Assessment Act 1997 Subsection 295-550(5). | Income Tax Assessment Act 1997 Subsection 295-550(6). | Taxation Administration Act 1953 section 357-110 | Taxation Administration Act 1953 section 359-25

Reasons for decision: Summary: The rate of return on the Fund's investment in the private company shares acquired is considered an unfavourable factor in the making of the Commissioner's decision. It is that rate of return that greatly increases the size of the dividend received on the sale of the shares above the dividend that would be received in an arm's length dealing. Therefore, the Commissioner is of the opinion that the transactions involving the acquisition and buy-back of shares from the Fund by the Company will not produce an arm's length outcome. Consequently, the proceeds on the proposed share buy-back by the Company held by ESP P/L for the Fund will be considered non-arm's length income of the Fund. | Detailed Reasoning - Detailed reasoning: In accordance with section 295-545 of the Income Tax Assessment Act 1997 (ITAA 1997), from 1 July 2007 the income of a complying superannuation fund, complying approved deposit fund or pooled superannuation trust is split into a 'non-arm's length component' and a 'low tax 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 any income derived from transactions where the parties are not dealing with each other at arm's length. 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 ' (TR 2006/7). 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 received by a complying superannuation fund will be non-arm's length income of the fund unless the amount is consistent with an arm's length dealing. In other words, is the dividend the same for the complying superannuation fund as it would be with any other shareholder? The factors listed in subsection 295-550(3) are to be considered in deciding whether there has been an arm's length result. Consequently, the Commissioner will consider if dividends paid to the Fund by ESP P/L, which in turn received dividends from the Company, produces an arm's length result. The entity in this case is the trustee of the Fund. The trustees, your client and your client's spouse, are also the fund members. The Fund is a complying self-managed superannuation fund. The private company in this case is a long established corporate entity conducting a business throughout Australia. The Company is proposing to buy back shares held by ESP P/L in respect of your client (the terminating employee of the Company), based on the market value of the shares. Dividends declared on ordinary shares in the Company are applied by ESP P/L in paying the unpaid amount on the shares it holds in the Company. Once the ESP P/L shares held by or on behalf of employees are fully paid, dividends are paid to shareholders of ESP P/L. Your client is one of two members and two trustees of the Fund and is also an employee occupying a managerial role in the Company. | Detailed Reasoning - Dividends: 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 (e) of the ITAA 1997 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) of the ITAA 1997. 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: (a) In deciding whether an amount is consistent with an arm's length dealing under subsection (2), have regard to: (b) the value of shares in the company that are assets of the entity; and (c) the cost to the entity of the shares on which the dividend was paid; and (d) the rate of that dividend; and (e) whether the company has paid a dividend on other shares in the company and, if so, the rate of that dividend; and (f) 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 (g) 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 the trustee of the Superannuation Fund (the Fund). The private company is the Company. ESP P/L owns a percentage of the issued share capital in the Company. ESP P/L holds ordinary shares in the Company for the Fund and this represents less than 1% of the total issued ordinary shares of the Company. The Fund is one of three shareholders who own shares in the Company. There are two other parties that hold shares in the Company. The exact value of the shares issued to one of these shareholders is not known as they were purchased more than 20 years ago. The applicant states that the value represented the proportionate interest held in the Company. The value of the shares issued to the second shareholder in the last five years was their then current market value. The shares issued to both the above entities were fully paid on issue. The value of the shares issued for the Fund was based on the value of the ordinary class shares in the Company as determined annually based on the audited accounts of the Company and a fixed formula in the ESP. The calculation of the market value of the shares has been reviewed by an accounting firm. The market value of the shares was over $15 in July 2009. The Fund purchased the shares in the 2009-10 income year. The Fund acquired the shares at a nominal value per share. Unlike the second shareholder, the fund did not pay the full market value on acquisition. As the shares have been objectively valued and then independently reviewed, it is accepted that the market value is reasonable. Shares were issued to the other shareholders using the same basis of valuation, therefore it is considered that the value of the share acquired by the Fund was determined on an arm's length basis. Overall, it is considered that these factors are neutral to the Commissioner considering that the income of the Fund is arm's length income. | Detailed Reasoning - Paragraphs 295-550(3)(c) and (d):: The Fund acquired ESP P/L shares, informally stapled to less than 1% of the total issued capital of ordinary shares of the Company. The Company's dividends are paid on an equal basis on all ordinary class shares. The same dividend is paid on a fully paid up share as is paid on an employee's share paid up to a nominal value. It is not pro-rated to take account of any unpaid share value. Therefore, although the Fund has paid a nominal value per share, it gets the same benefit from the dividends paid by the Company as does a shareholder whose shares are fully paid up. However, rather than the Fund receiving the dividend, while the employee's share remains only partly paid up, the dividend is applied to pay up the share. Only once an employee's share is fully paid up does the Fund receive the dividend in cash. This means that the cost of acquisition of the shares is being paid out of the profits of the Company. This is akin to receiving an interest free loan from the employer with which to buy the shares. On termination of employment of your client, the Fund will be entitled to a fully franked dividend otherwise than paid to the other shareholders. On their termination of employment, as a result of buying back the shares from the Fund, the Company will be declaring dividends on the shares purchased from the Fund but not on other shares. The reason for this, as stated by the applicant, is that at the time the shares held by ESP P/L are cancelled and the proceeds received in consideration of the cancellation will be in the form of a dividend. It is anticipated that it will be a fully franked dividend. Ultimately, the dividend the Fund receives when the shares are cancelled by the Company and ESP P/L comprises the full value of the dividends paid by the Company and applied to pay up the shares, as modified by any change in the value of the shares. As the Fund paid a nominal amount for each share, the first dividend it received represents more than 5,000% of its paid up purchase price. On the other hand, a non-employee shareholder paying full price for a fully paid up Company share on the same date would have received a dividend representing approximately 5% of its paid up purchase price. That the benefit the Fund received was not by way of cash dividend, but rather the paying up of its shares is not considered a relevant consideration, as ultimately, the increase in the paid up value will be returned to the Fund on sale of the shares. As a result, the rate of return on the Kennard's shares is much higher for the Fund than for shareholders not participating in the ESP. Overall, in view of the above, it is considered that these factors are unfavourable in respect of the Commissioner considering the income to be arm's length income. | Detailed Reasoning - Paragraph 295-550(3)(e):: The Company has not issued shares in satisfaction of a dividend. The shares have been issued as partly paid. The dividends declared and paid in the future will be applied to paying up the unpaid liability for the purchase of the shares. It is noted, though, that the dividends paid by the Company are applied first to the unpaid value of the shares it has issued to ESP P/L, and only when the shares are paid up do dividends flow to the Fund. This will be a neutral factor in determining if there is an arm's length outcome. | Detailed Reasoning - Paragraph 295-550(3)(f):: Your client, who with their spouse are the members of the Fund, is a director of the Company and also a director of ESP P/L. Both members of the Fund have no relationship to the major owners of the Company. The Fund holds less than 1% of the issued capital of the Company. Therefore the Fund does not hold a majority interest in the Company. Your client is a director of the Company and one of the Board members. Therefore, while they certainly have influence, they are not in a position to significantly affect the decisions of the Company, including the timing and amount of the payment of dividends. Therefore the state of the relationship between the members of the Fund and the Company is a favourable factor to the exercise of the Commissioner's discretion. The source of the funds used by the Fund to acquire the shares in the Company may have an influence on the decision made by the Commissioner. In this case, the source of the funds were savings in the Fund and future dividends paid on ordinary class shares in the Company. It is also relevant to consider whether the profits of the private company are largely dependant on the efforts of key personnel (such as a director) who are also members of the Fund. Where less than market salary is being paid to those key employees, the Commissioner considers that if what would otherwise be salary of an individual is being converted to dividends payable to a superannuation entity those dividends may be treated as non-arm's length income. There is no evidence that this has been done. You have advised that the salary paid to your client has not been reduced to convert it to dividends. Further, you state that the ESP was established as an incentive for senior employees of the Company to allow the employees to share in the profits of the Company through sharing of dividends and the growth of the Company. There are more than 30 employees involved in the ESP. It does not apply only to your client. However, the scheme is not open to every employee of the Company, let alone the general public. Less than 5% of the Company's employees are ESP participants. Participants in the scheme are typically management or executives of the Company and participate in the ESP at the invitation of the Company Board, of which your client is a part. Therefore, the restrictions in participation in the scheme is an unfavourable factor to the exercise of the Commissioner's discretion. Overall, this is considered a neutral factor in supporting the view that the Fund has dealt at an arm's length relationship with the Company and that the transactions were conducted in an arm's length manner that produced an arm's length outcome. | Detailed Reasoning - Conclusion:: On the whole, having regard to the matters listed paragraphs 295-550(3)(a) to (f) of the ITAA 1997, the Commissioner is of the opinion that the transactions involving the buyback of shares from the Fund by the Company will not produce an arm's length outcome. Therefore the proceeds on the proposed share buy-back by the Company held by ESP P/L for the Fund will be considered non-arm's length income of the Fund as defined by section 295-550 of the ITAA 1997. | Detailed Reasoning - Ruling on future years of income: The applicant has requested that the Commissioner issue a ruling for the period 1 July 2009 until the employee terminates his employment with the Company. In this case, the Commissioner proposes to only provide a ruling for the 2011-12 income year. While section 359-25 of the Taxation Administration Act 1953 (TAA 1953) allows the applicant to request a ruling for a future year of income, section 357-110 of the TAA 1953 states that: If the Commissioner considers that the correctness of a private ruling would depend on which assumptions were made about a future event or other matter, the Commissioner may: (a) decline to make the ruling; or (b) make such of the assumptions as the Commissioner considers to be most appropriate. In this case, in order to make a ruling on a future year, the Commissioner would have to make assumptions on the following matters, central to the administration of section 295-550 of the ITAA 1997: · the funds level of shareholding, and associated voting rights; · whether a person or entity associated with the fund occupies a decision making position with the company and uses that position to unduly influence the payment of dividends; · that the dividends returned to the fund by the company do not become more favourable than other ESP participants; and · that the fund continues to be a complying superannuation fund. The Commissioner is not willing to make assumptions on these matters, and accordingly declines to rule for the 2012-13 income year and subsequent years.

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