Private ruling: Non-arm's length income
Published: April 2014
Ruling period: Year of income ending 30 June 2014.
Date scheme commenced: 1 July 2013

Ruling: Q1: Will dividends received by the Self Managed Superannuation Fund as a result of the proposed acquisition of the share in a private company be non-arm's length income of the Fund in accordance with section 295-550 of the Income Tax Assessment Act 1997 (ITAA 1997)? | A1: No.

Relevant facts and circumstances: 1. Taxpayer 1 and Taxpayer 2 are members of the Self Managed Superannuation Fund (the Fund). 2. Both Taxpayers 1 and 2 are of retirement age and employed full time during the year ending 30 June 2014 and therefore satisfies the 'work test' for making superannuation contributions. 3. D Pty Ltd (the Trustee) is the corporate trustee of the Fund. 4. Taxpayer 1 and Taxpayer 2 are the only directors and shareholders of the Trustee. 5. Taxpayer 1 is the sole director and shareholder of the Company. Taxpayer 1 owns the one issued share of The Company. 6. It is intended to transfer the share at market value to the Fund. At the time of the transfer all operational activity of the Company will have ceased. The only asset of the Company will be cash. The Company will have no borrowings. The Company has franking credits in its franking account. 7. At the time of the transfer of Taxpayer 1's share in The Company to the Fund, an estimated value is determined. 8. The market value of the share in The Company is said to be equal to the franking credits plus the retained earnings. 9. Upon transfer, the Trustee of the Fund will treat $X as a non-concessional contribution made for Taxpayer 1; $Y as a contribution covered by section 292-100 of the ITAA 1997 under the capital gains tax (CGT) small business retirement exemption and made for Taxpayer 1; and the balance as a non-concessional contribution for Taxpayer 2. 10. The share received by the Fund will be recorded in the Fund's accounts at the market value. 11. After the expiry of 45 days, The Company will pay out all its retained earnings (i.e. the only asset of The Company) by way of fully franked distributions to the Fund. This will result in a total franked distribution with a franking credit on the distribution being paid to the Fund. 12. The dividend income will be available for distribution to the members as pension income over a period as the members require. 13. The Company will be wound up once all retained earnings have been distributed to the Fund. It is anticipated that the Company will be wound up between 2019 and 2022.

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).

Reasons for decision: Detailed Reasoning - Summary of decision: 14. As the shares are acquired by the Fund at market value, the dividends received by the Fund from The Company will not be treated as non-arm's length income of the Fund. | Detailed Reasoning - Detailed reasoning: 15. 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'. 16. 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 (45%). These rates are set out in the Income Tax Rates Act 1986 . 17. 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. 18. 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). 19. 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. 20. 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. 21. In the facts of this case the share is to be contributed at its stated market value, such that the share is reflected at that market value in the members' accounts. This is a relevant consideration under paragraph 295-550(3)(a) of the ITAA 1997 and the acquisition of shares at market value is consistent with an arm's length dealing. 22. The Fund as the only shareholder will receive all of the retained earnings of The Company as a dividend distribution (or distributions) which will be fully franked. This will in effect provide the Fund with a dividend rate equal to 100% of the assets of The Company for minimal or nil investment risk, which may be considered more consistent with a non-arm's length dealing (paragraphs 295-550(3)(c) and (f)). However, this has to be balanced against the Fund's acquisition value of the share and that as the only shareholder following the acquisition of the share the Fund is the only entity to which the distribution of retained earnings can be made. There are no other shareholders and therefore the rate of dividends on other shares (as mentioned under paragraph 295-550(3)(d) of the ITAA 1997) is not relevant. Further, The Company has not issued any shares to the Fund in satisfaction of a dividend paid by the company (as mentioned under paragraph 295-550(3)(e)) and therefore this is not relevant. 23. Although the matter is not without doubt we consider that in the circumstances the dividend income paid to the Fund by The Company should not be treated as non-arm's length income for the Fund.