In short, the ruling can provide valuable opportunities for those who plan properly.
The ruling: TR 2006/7
In its final ruling (previously issued as draft ruling TR 2006/D1), the Commissioner sets out his preliminary views on whether income of a complying superannuation fund is ‘special income’ which is taxed under income tax law at 45%, rather than the concessional rate of 15%.
What is ‘special income’?
There are four different types of special income. These are:
- dividends paid by a private company, including income derived indirectly from a dividend and non-share dividends;
- income from a transaction where the parties are not dealing at arm’s length;
- income received from a trust in the capacity of a beneficiary other than by virtue of holding a fixed entitlement; and>/li>
- non-arm’s length income received from a trust in the capacity of a beneficiary holding a fixed entitlement.
The final ruling reaffirms the ATO view that ‘income’ is to be interpreted widely. According to the ATO it can include both income according to ordinary concepts and amounts included in assessable income under a statutory provision (numerous tax experts differ on this point). This means that capital gains and franking credits can be special income.
Furthermore, once an amount of income has the character of special income, then the whole amount is special income. The amount cannot be divided between what is not special income and what is; ie, one in, all in.
Dividends paid by a private company
The ruling provides that dividends paid by a private company are special income unless the Commissioner is of the opinion that it would be reasonable not to treat the dividend as special income, having regard to the matters listed in the legislation.
No one matter is determinative.
Income that is derived indirectly from a dividend paid by a private company can also be a dividend paid to the entity by the company under s 273(2) of the Income Tax Assessment Act 1936 (Cth) (‘ITAA’).
In other words, a private company dividend that is derived by a fund from an interposed entity (eg, a unit trust) is indirectly derived from a dividend and will be special income unless the Commissioner determines otherwise.
The trustee may self-assess whether to treat a private company dividend as special income or not having regard to the particular circumstances.
However, if the trustee is uncertain as to whether or not the Commissioner will exercise his discretion, ie, treating the dividends as not special income, the trustee should seek clarification by requesting a private ruling.
Dividends that are not special income
Broadly, the ruling confirms that private company dividends should not be treated as special income where the dividends are derived on an arm’s length basis.
The ruling confirms that dividends are only derived on an arm’s length basis where the shares are acquired, the investment is maintained, and the dividends are paid on an arm’s length basis.
The ruling confirms that even if the parties are related, the dividends will not be treated as special income if those parties deal at arm’s length.
This also means that the Superannuation Industry (Supervision) Act 1993 (Cth) (‘SISA’) is not contravened where the shares in a company are owned by an SMSF and the company leases the business real property from the SMSF.
This, combined with self-assessment, is an opportunity for super funds to structure and take advantage of this flexibility. The ATO issued very few favourable rulings prior to the issue of TR 2006/7.
This also means conversely, if the fund acquires shares in a company for less than market value, any dividends paid on those shares, prima facie, are considered to be special income.
Factors in determining special income
If the shares in the private company are paid-up to a different extent, and there are no other matters that the Commissioner considers to adequately explain the difference, the Commissioner will treat the dividend as special income.
It also means if the rate of dividends paid to the SMSF is greater than other shareholders, and the difference does not reflect underlying commercial risks, it is likely the Commissioner would treat the dividend as special income.
Where the shares are of different classes, then differing rates of return may be more easily justified. Therefore, in general, the higher the rate of dividend paid as a return to shareholders, the more difficult it is to justify that the rate is at an arm’s length and so the dividend will be held as special income.
In exercising his discretion, the Commissioner may also consider:
- the extent to which shareholders who are at arm’s length to the private company have an interest in the SMSF;
- the relationship between the SMSF and the private company;
- the relationship between the SMSF and any party with which the private company has dealings; and
- who the SMSF acquires the shares from and the circumstances of that acquisition.>
A simple example from the ruling showing a favourable outcome is as follows:
A private company ABC has 2 shareholders, X and Y SMSFs. X Super Fund has 2 members, Mr & Mrs Smith, who are also employees of ABC. The two SMSFs acquired all the shares (50% each) in ABC at $1 per share. Y Super funds has two members, Mr & Mrs Jones, who are directors of ABC.
Both the Smiths and the Jones are paid market rate salary by ABC. X Super Fund owns the business real property which ABC runs its business, and the rent paid by ABC to X super fund is at market rate.
ABC makes large profits and pays the same amount of dividends to both SMSFs, reflecting the large profits made by ABC.
Although the relationship between the super funds and ABC are not at arm’s length, however, the rate of dividend generated is at arm’s length.
The rental of the business real property is also at arm’s length. Therefore, although the parties are related, the ATO therefore conclude, their dealings with each other are at arm’s length.
It is reasonable to not treat the dividends paid by ABC as special income.
It is critical that any transaction carried out is commercial, and appropriately documented. By having proper documentation, you then have evidence to prove that the transactions, pricing and decision-making are properly recorded.
In many cases investments by SMSFs in private companies will give rise to a range of other regulatory issues; especially the in-house asset (‘IHA’) rules in Part 8 of SISA. As a breach of these rules can result in substantial penalties, extreme care is required.
Many SMSF deeds give rise to unnecessary IHA risks. In particular, an employer-sponsored fund can easily invoke the IHA rules. These can generally be overcome with a quality SMSF deed.
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