Sections 295-550(2) and (3) provide:

(2) An amount of ordinary income or statutory income is also non-arm's length income of the entity if it is:

(a) a dividend paid to the entity by a private company; or

(b) ordinary income or statutory income that is reasonably attributable to such a dividend;

unless the amount is consistent with an arm's length dealing.

(3) In deciding whether an amount is consistent with an arm's length dealing under subsection (2), have regard to:

(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.

ATO position — TR 2006/7:

The ATO’s position in relation to private company dividends and NALI is outlined in some detail in TR 2006/7. TR 2006/7 confirms that, to the extent that s 295-550 expresses the same ideas as the former ruling on NALI regarding s 273 of the Income Tax Assessment Act 1936 (Cth) (ITAA 1936), the ruling is also taken apply to s 295-550.

The following paragraphs are from TR 2006/7:

Dividends paid by a private company

13. Subsection 273(2) provides that a dividend that is paid by a private company to a complying superannuation fund, … is special income of the entity 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 subsection 273(2).

Self-assessment

14. This Ruling sets out the way in which the discretion in subsection 273(2) will be exercised by the Commissioner. A trustee may self-assess as to whether or not to treat a dividend as special income by applying this Ruling to their particular circumstances. If the trustee is uncertain as to whether or not the Commissioner will exercise the discretion, the trustee should seek clarification by requesting a private ruling.

17. In order to decide whether the Commissioner will form the opinion that it would be reasonable not to treat a dividend as special income, the Commissioner will have regard to all of the matters in paragraphs 273(2)(a) to (e) and any other matters that the Commissioner considers relevant in accordance with paragraph 273(2)(f). No one matter is determinative. The importance attached to any particular matter may vary depending on the facts of the case. While some matters may be unfavourable to the Commissioner exercising the discretion, others may be favourable.

18. The Commissioner will form the opinion that it would be reasonable not to treat the dividend as special income when the dividends are derived on an arm's length basis. The Commissioner will consider paragraphs 273(2)(a) to (e) as matters that indicate whether or not the dividends are derived on an arm's length basis. The Commissioner will consider a matter to be relevant under paragraph 273(2)(f) if it indicates whether or not the dividends are derived on an arm's length basis.

19. Dividends are only derived on an arm's length basis when the shares are acquired, the investment is maintained, and the dividends are paid on an arm's length basis. If the shares are acquired at market value, the private company is not involved in non-arm's length dealings and the rate of dividend is the same as the rate of dividend paid on other shares in the company or is reasonable having regard to investment risk, and there are no other matters that the Commissioner will consider relevant, the Commissioner will form the opinion that it would be reasonable not to treat the dividend as special income.

Note that the references in TR 2006/7 to s 273(2)(a) to (f) of the ITAA 1936 were replaced by s 290-550(3)(a) to (f) of the ITAA 1997 from 1 July 2007.

Case law:

There are two notable cases where NALI was applied to dividends derived by an SMSF from private companies being Darrelen Pty Ltd v Commissioner of Taxation [2010] FCAFC 35 (Darrelen) and GYBW and Commissioner of Taxation [2019] AATA 4262 (GYBW).

Darrelen involved a case where an SMSF acquired shares in a private company at less than 10% of the market value of those shares. The dividends in each of the relevant years of income were far in excess of the purchase price that the trustee of the Fund had paid for the shares. In this regard, against an acquisition cost of $51,218 (paid in October 1995), the trustee of the fund received dividends as follows: in the year ended 30 June 1996 – $26,400; in 1997 – $208,136; in 1998 – $140,000; in 1999 – $125,200; in 2000 – $143,720; in 2001 – $143,720; in 2002 – $86,320 and in 2003 – $76,640. The full Federal Court confirmed the Tribunal’s decision that the dividends were to be taxed as NALI. This resulted in $950,136 in dividends plus franking credits over an eight-year period.

GYBW involved a case where an employee’s SMSF was provided with favourable terms to acquire shares in the employer’s company. The employee’s SMSF acquired shares at a nominal value of $200 which produced substantial dividends (eg, a dividend of $672,900 with a $288,283.71 franking credit for FY2013, a dividend of $1,050,000 with a $450,000 franking credit for FY2014 and a dividend of $70,000 with a $30,000 franking credit for FY2015; being a total of $1,792,900 in dividends and $768,283.71 in franking credits over three financial years). The Tribunal held that s 290-550 did apply and relied on the analysis of the Full Federal Court in Darrelen. In particular, the Tribunal confirmed that:

· s 295-550(2) is not limited to an enquiry about the circumstances surrounding the payment of the dividend, but can extend the circumstances surrounding the acquisition of shares;

· it is not sufficient to merely show that dividends are paid on all shares in the company, including those owned by the SMSF, on an equal basis without preference;

· regard must be had to all of the factors in s 290-550(3)(a) to (f); not just some of them; and

· the reference to ‘value’ in s 290-550(3)(a) is a reference to market value.

Broadly, in each of Darrelen and GYBW a careful analysis of each of the factors in s 290-550(3)(a) to (f) was undertaken to determine whether NALI applied to dividends received from the SMSF’s acquisition of shares in a private company. In each case the analysis concluded that the shares had been acquired for less than market value.

The application of the dividend NALI provisions provides a relatively structured analysis compared to the general NALI provisions.

Non-fixed trust NALI

Legislative overview:

Section 295-550(4) provides:

(4) Income derived by the entity as a beneficiary of a trust, other than because of holding a fixed entitlement to the income, is non-arm's length income of the entity.

ATO Position — TR 2006/7:

The Commissioner in TR 2006/7 provides some context to the meaning of fixed entitlement in relation to s 273 (see paragraphs 205-209). Broadly, where the entitlement is an investment in units in a 'unit trust', the units would generally be accepted as conferring fixed entitlement unless the distributions were non-fixed or discretionary.

In comparison, distributions made to a beneficiary of a 'discretionary trust' from the exercise of discretion would not be fixed. Typically, income derived from fixed entitlements should only be treated as NALI if the acquisition of the fixed entitlement or the derivation of the income failed to satisfy an arm's length test.

Fixed trust entitlement NALI

Legislative overview:

Section 295-550(5) provides:

(5) Other income derived by the entity as a beneficiary of a trust through holding a fixed entitlement to the income of the trust is non-arm's length income of the entity if, as a result of a scheme the parties to which were not dealing with each other at arm's length in relation to the scheme, one or more of the following applies:

(a) the amount of the income is more than the amount that the entity might have been expected to derive if those parties had been dealing with each other at arm's length in relation to the scheme;

(b) in acquiring the entitlement or in gaining or producing the income, the entity incurs a loss, outgoing or expenditure of an amount that is less than the amount of a loss, outgoing or expenditure that the entity might have been expected to incur if those parties had been dealing with each other at arm's length in relation to the scheme;

(c) in acquiring the entitlement or in gaining or producing the income, the entity does not incur a loss, outgoing or expenditure that the entity might have been expected to incur if those parties had been dealing with each other at arm's length in relation to the scheme.

Accordingly, where the relevant trust provides a ‘fixed entitlement’, there must be greater income derived or a lower (or no) expense incurred before the NALI provisions will be enlivened.

However, where the relevant trust does not provide a fixed entitlement, eg, a distribution from a family discretionary trust, the income received will be NALI. It is generally accepted that distributions from ‘discretionary trusts’ will result in that income received by an SMSF trustee being taxed as NALI. The Commissioner also considers distributions to an SMSF from a discretionary trust will give rise to a contribution.

In reviewing unit trust deeds, a careful review of the deed is required to determine whether the trust confers fixed or discretionary entitlements. We would be pleased to assist in this regard.

Case Law:

The High Court in CPT Custodian Pty Ltd v Commissioner of State Revenue (2005) 224 CLR 98 confirmed at [15] that:

However, "unit trust", like "discretionary trust", in the absence of an applicable statutory definition, does not have a constant, fixed normative meaning …

The Federal Court in Colonial First State Investments Limited v Commissioner of Taxation [2011] FCA 16 confirmed that a managed investment trust that allowed a 75% vote to amend the governing rules (referred to as a ‘constitution’ in this case) of the trust did not qualify as a fixed trust as there was the possibility, although it was unlikely to be exercised, for the majority to dilute the 25% minority’s interests in that trust.

An important practical aspect of TR 2006/7 is the Commissioner’s view on what is required for a ‘fixed entitlement’. TR 2006/7 provides:

209. To have an interest in the income of a trust estate, a person must have a right with respect to the income of the trust that is susceptible to measurement; a right merely to be considered as a potential recipient of income is not sufficient. An interest in the income of a trust estate will be vested in interest if it is bound to take effect in possession at some time and is not contingent upon any event occurring that may or may not take place. ...

However, ‘fixed entitlement; is defined in s 995-1 of the ITAA 1997 as:

an entity has a fixed entitlement to a share of the income or capital of a company, partnership or trust if the entity has a fixed entitlement to that share within the meaning of Division 272 in Schedule 2F to the Income Tax Assessment Act 1936.

The definition of fixed entitlement is aligned to that same term of ‘fixed entitlement’ in the trust loss measures in Schedule 2F of the ITAA 1936, which is a much stricter definition of fixed entitlement compared to the ATO’s views expressed in TR 2006/7. The application of the definition of fixed entitlement provided in Schedule 2F of the ITAA 1936 was also confirmed by the AAT Senior Member in The Trustee for MH Ghali Superannuation Fund and Commissioner of Taxation [2012] AATA 527 (Ghali).

ATO position:

In the ATO’s Decision Impact Statement after Ghali, the Commissioner proposed to adhere to his view that the Schedule 2F definition is inapplicable for the purposes of the NALI provisions.

Notably, in PCG 2016/16 at [4] the Commissioner states that his view of fixed entitlement in respect of s 273 of the ITAA 1936 and s 295-550 of the ITAA 1997 is explained in TR 2006/7.

In view of this analysis, a fixed unit trust should be used where an SMSF invests in a unit trust as many unit trusts that the authors have reviewed include some form of hybrid or discretion that may not qualify as a fixed entitlement especially if the Commissioner’s current administrative view changes sometime in the future.

One simple test to determine whether a unit trust is fixed for Schedule 2F ITAA 1936 purposes is to check whether 100% unitholder consent is required to vary the trust deed. Stone J in the Colonial First State Investments decision commented that a 75% majority provided the possibility that the minority interests could be diluted.

Conclusions

Careful planning and management is required where SMSFs invest in private companies and unit trusts. SMSF trustees must ensure they consider the factors outlined s 295-550(3) to minimise the risk that dividends received from private company shares will not enliven (dividend) NALI in s 295-550(2).

Where an SMSF receives income from a trust, it is vital to ascertain whether the trust deed confers fixed or discretionary entitlements. Discretionary or ‘non-fixed’ trust entitlements will give rise to NALI under s 295-550(4), whereas ‘fixed entitlement’ NALI under s 295-550(5) requires that mire income is derived or a lower (or no) expense is incurred before the NALI provisions will be enlivened.

Unfortunately, there is no discretion in the NALI provisions for honest and inadvertent mistakes. However, timely rectification generally minimises risk.