Avoiding tax consequences with the related-party rules
The impact of provisions in the Income Tax Assessment Act on transactions where there is an acquisition of shares in a company that will carry on a business is critical, but is often overlooked.
One issue that is commonly raised for advice by SMSF trustees and advisers is whether a proposed transaction will result in a compliance issue. Often the transaction will involve business real property and there will usually be options as to how to hold the asset (eg directly in the fund, or if a minority interest as tenants in common or via an un-geared trust or company or if there is a need to borrow, use an LRBA arrangement with a holding trust). Simple is usually best, so commonly the asset will be held by the trustee. Treat it as a commercial transaction, including paying an arm’s-length price and entering into a lease on commercial terms, and there will be few issues (at least while the business is going well). Take great care however if there is any residential component as it is surprising how many commercial premises have a small unit attached, sometimes with a separate tenant but not on a separate title. In that case the property may not meet the definition of business real property and cannot be acquired from a related party or leased to one without becoming an in house asset.
However, the issue can become much more complicated where the transaction involves the fund acquiring shares in a company which will carry on a business. In this case, the answer is always going to depend on the facts, but an important criteria is that the company that operates the business must not be a related party of the fund. Another critical, but often overlooked aspect, is the impact of the non-arm’s length income provisions of the Income Tax Assessment Act.
In two recent scenarios presented to us, we gave different answers on what were very similar structures. However, there were some important differences to be aware of.
In the first case, the proposal was as follows:
- A private company was to be established with a view to acquiring an existing business from a third party.
- Our client’s SMSF was to acquire a minority interest in this private company (ie not more than 50 per cent).
- The other two shareholders of the company were family trusts but the controllers of these trusts were unrelated to our client with no common business interests or joint income (ie they were not Part 8 associates).
- There were to be three directors of the company – one director to represent each shareholder, and they would each be paid directors’ fees. One of the directors, not our client, would be the managing director and responsible for running the business.
Great care had been taken in the planning to ensure the SMSF would be unable to control the private company via its shareholding or directorship, and the client was clearly aware of the pitfalls so had ensured there were no joint bank accounts or business connections between the shareholders. We highlighted the need to continually monitor compliance with the control restrictions, particularly as circumstances changed, and recommended shareholder agreements also took account of the control restrictions. Out of caution, we also recommended that no employer contributions were paid to the SMSF by the private company. We also advocated documenting in the fund’s investment strategy the thinking on this new investment. This would assist the approved auditor and provide a useful record should there be disputes within the fund or with the ATO in the future.
In essence, we could see no reason why this proposed transaction could not proceed.
However, in the second case, our answer was different in what was essentially a very similar structure. The issue in the second situation arose from the fact that this was not an existing business being acquired at an arm’s length price. Instead, the proposal was for the private company to create a new business based on the intellectual property of the principals and their perceived ability to obtain service contracts from a large public entity. It was believed that the public company would contract with the new company because of its existing relationship with the principals and the fact the principals were already doing similar work in their personal capacity.
In our view, the structure could potentially work from the perspective of the Superannuation Industry (Supervision) Act provided there was no financial assistance to the principals. Similar issues would have arisen as with the first scenario with the need for ongoing monitoring of the in-house asset rules and the 50 per cent limit, and the desirability of recording the transaction within the investment strategy.
However our concern in the second case was with the non-arm’s length provisions of the Tax Act. In our view, the existence of contracts already in place between the public company and the principals made it likely that the ATO would have concerns. Ultimately, we expressed our doubts and, if the transaction was to proceed, we recommended our client made an application for a private binding ruling from the ATO. We recommended this course fully aware that the process would be an additional expense, may be slow and may not produce a positive answer. However, it would be very expensive to reverse these arrangements if the Commissioner formed the view, after the business commenced, that any dividends were non-arm’s length income.
Making sense of the related party rules is one of the more difficult aspects of advising in the area of SMSF compliance and should be approached with great care.
Stuart Forsyth, McPherson Super Consulting director
Columnist: Stuart Forsyth
Friday 4 September 2015