Private ruling: Non-arm's length income
Published: February 2012
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? Advice/Answer: No.


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).

Reasons for decision: Summary: The Commissioner is of the opinion that the transactions involving the acquisition and buy-back of shares from the Fund by the Company will produce an arm's length outcome. Consequently, the proceeds on the proposed share buy-back by the Company held by the Employee Share Company for the Fund will not 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) 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) of the ITAA 1997 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 the Employee Share Company, 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 are also the fund members. The Fund is a complying self-managed superannuation fund. The Company in this case is a entity operating throughout Australia. The Company is proposing to buy back shares held by the Employee Share Company in respect of a member. The member is a trustee of the Fund and is also an employee of 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 (f) 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: In deciding whether an amount is consistent with an arm's length dealing under subsection (2), have regard to: o the value of shares in the company that are assets of the entity; and o the cost to the entity of the shares on which the dividend was paid; and o the rate of that dividend; and o whether the company has paid a dividend on other shares in the company and, if so, the rate of that dividend; and o 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 o 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 Fund. The value of the ordinary shares held by the Employee Share Company in respect of the Fund is determined annually based on the audited accounts of the Company and a fixed formula. The calculation of the market value of the shares has been reviewed by an independent entity. 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. It is also noted that the cost of the Employee Class Share is the price paid by all participants in the plan. No further amount is payable on those shares. Overall, it is considered that these factors are favourable 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 Company's dividends are paid on an equal basis on all ordinary class shares. On termination of employment of an employee participant, the following occurs: The Company shares held by the Employee Share Company 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. The Employee Class Share held by the participating employee or the employee's nominee is cancelled. The Fund will receive an amount which is applicable to all other participants in the plan. The formula reflects the value of the shares in the Company at the relevant time. Overall, in view of the above, it is considered that these factors are favourable 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. This will be a neutral factor in determining if there is an arm's length outcome. | Detailed Reasoning - Paragraph 295-550(3)(f):: A member of the Fund is a director of the Company and also a director of the Employee Share Company. The Fund has a small indirect holding of the issued capital of the Company. Therefore the Fund does not hold a majority interest in the Company. While a member of the Fund has some influence, the member is 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 was 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. The applicant has advised that the salary paid to a member of the Fund has not been reduced to convert it to dividends. In addition, the Company board has resolved to make participation in the employee share plan available to a much broader base of employees in the future. Overall, this is considered a favourable 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 produce an arm's length outcome. Therefore the proceeds on the proposed share buy-back by the Company held by the Employee Share Company 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 a member of the Fund 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: o the funds level of shareholding, and associated voting rights; o 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; o that the dividends returned to the fund by the company do not become more favourable than other employee share plan participants; and o 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.

Please check this edited version to be sure that there are no details remaining that you think may allow you to be identified. If you have any concerns about this ruling you wish to discuss, you will find our contact details in the fact sheet. | Relevant facts: The Fund is a self managed superannuation fund (SMSF). | A member of the Fund is an executive officer of a company (the Company). | The Company has around many employees and operates throughout Australia. | The Company operates an employee share plan. | The Employee Share Company was established to conduct the employee share plan. | Participating employees acquire shares in the Employee Share Company (Employee Class Share). | In turn, the Employee Share Company acquires ordinary shares in the Company in relation to the employee concerned. Ordinary shares in the Company are acquired by the Employee Share Company for the benefit of participating employees. | The Company board has resolved to make participation in the employee share scheme available to a much broader base of employees. | On commencement of employment, a member of the Fund was invited to participate in the employee share plan and nominated the Fund to participate. | The Fund purchased Employee Class Shares. In turn, the Employee Share Company acquired ordinary shares in the Company. | The market value of the shares in the Company is determined annually under the plan based on a formula. | Dividends are paid equally per share. | The Employee Share Company shares in the Company which have the same rights as all other ordinary shares in the Company. | The dividend policy of the Company is such that an annual dividend equal to a percentage of the after tax profits of the previous year are distributed as a fully franked dividend. | o The Company shares held by the Employee Share Company in respect of the employee are bought back by the Company at the market value of the Company shares for that year of income. | o The Employee Class Share held by the participating employee or the employee's nominee is cancelled. | Accordingly, the Fund holding Employee Class Share under the employee share plan will be entitled to receive: | o Fully franked dividends during the course of the Fund's participation in the Plan where the Company shares are fully paid; and | o A lump sum amount as a fully franked dividend on termination of employment. | The Company Board and Board members of the Employee Share Company operate at arm's length. | The Company is audited by an independent entity and has its accounts prepared by an independent firm. | The calculation of the market value of the Company shares and the dividends paid by the Employee Share Company is reviewed by an independent entity.