'Special income' aka 'non arm's-length income' and complying superannuation funds including SMSFs — recent case: Darrelen Pty Ltd v Commissioner of Taxation

In certain circumstances, a complying superannuation fund's (which includes SMSFs) income will be taxed at the highest marginal rate and not the concessional rate that normally applies to the fund's income. A complying superannuation fund's (fund) income that is taxed at the highest marginal rate is referred to as:

• for the income tax years up until the year ended 30 June 2007, 'special income'[1]; and
• for later years, 'non arm's-length income'[2].

Both the old legislation and the new legislation provide that dividends paid from a private company to a fund will be taxed as 'special income' or 'non arm's-length income' at a rate of 45% — unless the Commissioner of Taxation decides otherwise.

The recent case of Darrelen Pty Ltd v Commissioner of Taxation[3] analysed when the Commissioner should exercise his discretion to decide otherwise.

The facts

In October 1995, the trustee of a complying superannuation fund (Fund), purchased 4 of the 100 shares on issue in Vercot Pty Limited (Vercot). Vercot was a passive holding company that held shares in Abigroup Limited (Abigroup), a listed public company. Other relevant facts are:

• The Fund acquired the shares from an associate of the Fund;
• The shares had a market value significantly higher than the $51,218 the Fund paid for them; and
• Vercot always paid dividends to shareholders (including the Fund) in proportion to their shareholdings.

The question

The Commissioner had to decide whether any of the dividends Vercot paid to the Fund should be treated as special income and taxed at the higher rate. [4]

The Commissioner's decision

The Commissioner decided to treat the dividends paid to the Fund as 'special income' and so they were taxed at the higher rate.

The Commissioner did not decide whether the Fund's acquisition of the shares from a related party breached the Superannuation Industry (Supervision) Act 1993 (SIS Act). However, as explained below, the circumstances of that transaction were relevant to the Commissioner's decision about taxation treatment of later dividends.

What were the issues in this case?

The Federal Court considered whether:

• the dividends Vercot paid should be treated as 'special income', under section 273(2) of the ITAA 1936; or
• the Commissioner should have exercised his discretion and not treated the dividends as 'special income'.

The law requires the Commissioner to consider the following when exercising his discretion[5]:

• the value of the shares that are assets of the fund;
• how much the fund paid for the shares on which the dividend was paid;
• the rate of the dividend paid to the fund measured against the cost of those shares to the fund;
• whether the company has paid a dividend on other shares in the company and, if so, the rate of that dividend;
• whether any shares have been issued by the company to the fund in satisfaction of, or in satisfaction of a part of, a dividend paid by the company and, if so, the circumstances of the issue of those shares; and
• any other relevant matters.

(Those factors under the old law for 'special income' are now in force — and exactly the same — under the new law for 'non arm's-length income'.[6])

What did the Court decide?

The Court found that the Commissioner was entitled to not exercise his discretion and to treat the income as 'special income' and tax it at 45%.

In coming to that view, the Court felt it was highly relevant that the Fund acquired the shares for less than market value. The Court highlighted that the investment was not made on 'arm's length terms' and held that the investment enabled the Fund to derive a greater level of income than had the Fund paid market value for the shares.

What implications arise from the decision?

Although the decision only focused on private company dividends, the Court gives us a clear message that if a fund transacts with a related party, then the transaction has to be effected on 'arm's length terms'.

If the transaction is not effected on 'arm's length terms' and the return generated by the fund is above market value, then it is likely that the income will be regarded as 'special income' and not taxed concessionally.

In short, all transactions with related parties should:

• be effected at 'arm's length', or as if the parties are at 'arm's length';
• be subject to independent valuations;
• have modelling that supports that the returns generated by the fund are not over and above a market return; and
• be evaluated for compliance with the general prohibition on acquisitions from related parties (section 66 of the SIS Act).

More information from Maddocks

For more information, contact Maddocks on (03) 9288 0555 and ask for a member of the Maddocks Tax and Revenue Team.

More Cleardocs information on superannuation and taxation issues - www.cleardocs.com

Read

You can access various ClearLaw articles for more relevant information relating to superannuation and taxation issues:

• ClearLaw 'Superannuation' articles
• ClearLaw 'Tax (Legislation and Law)' articles

Order Cleardocs superannuation products

• Superannuation Trust (SMSF)
• Update to SMSF
• Change of Trustee
• SMSF Pension Pack
• SMSF Borrowing (related party)
• SMSF Borrowing (bank)
• Death Benefit Agreement
• Death Benefit Nomination

Download checklist

Download a checklist of the information you need to order a document package.

[1] Regulated by Division 273 of the Income Tax Assessment Act 1936 (ITAA 1936).

[2] And is regulated by Subdivision 295-H of the Income Tax Assessment Act 1997 (ITAA 1997).

[3] 2010 FCAFC 35.

[4] And be regulated by Subdivision 295-H of the ITAA 1997.

[5] Section 273(2) of the ITAA 1936

[6] Section 295-550(3).