Explanatory Memorandum
(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)Chapter 2 - Non-arms length trust distributions etc. to superannuation and similar funds
Overview
2.1 Schedule 2 to the Bill will amend section 273 of the Income Tax Assessment Act 1936 (ITAA 1936) so that the special income of a complying superannuation fund, approved deposit fund (ADF) or pooled superannuation trust (PST) will include:
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- distributions from all trusts other than where the superannuation fund, ADF or PST has a fixed entitlement to income from that trust; and
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- non arms length trust distributions of income where the superannuation fund, ADF or PST has a fixed entitlement to income from that trust.
Summary of the amendments
2.2 To tighten section 273, an existing anti-avoidance measure, to close a loophole which allows certain distributions of trust income to superannuation funds made under non-arms length arrangements to be taxed at the concessional rate of 15%.
2.3 The amendments will apply (subject to the transitional arrangements discussed in paragraphs 2.5 2.10) to income derived by a complying superannuation fund, ADF or PST (a superannuation entity) after 2pm by standard time in the Australian Capital Territory on 25 November 1997 (ie., the amendments will apply from the time of the Treasurers Press Release). [Item 3]
2.4 The amendments are strictly anti-avoidance in nature. The amendments were originally introduced on 2 July 1998 in Taxation Laws Amendment Bill (No. 5) 1998. The Bill lapsed on the announcement of the Federal Election.
2.5 The amendments are different in form to the measures announced on 25 November 1997. The announcement stated that the tax law would be amended so that trust distributions made from all trusts, other than unit trusts, to a superannuation entity would be treated as special income of the fund and taxed at the non-concessional rate of 47%. It was also announced that the law would be clarified to ensure that distributions from unit trusts to superannuation entities made in excess of an arms length amount would also be taxed at 47%.
2.6 There will be cases of genuine arms length investments by superannuation entities in fixed trusts that are not unit trusts. Under the announcement income from such investments would automatically be treated as special income. It is more appropriate that investments of these kinds, involving a return by virtue of holding a fixed entitlement, be subject to the arms length test. The amendments will apply in this way.
2.7 The majority of investments by superannuation entities in unit trusts will be held as fixed entitlements. However, there may be circumstances where investments in unit trusts could be held other than as a fixed entitlement.
2.8 Consequently, a transitional arrangement will apply from the date of the announcement until the end of the day of introduction of the legislation into the Parliament which first occurred on 2 July 1998. This will ensure that superannuation entities that relied on the details contained in the announcement and which would otherwise be adversely affected under the amendments will be treated in accordance with the details as announced.
2.9 Accordingly, Item 4 ensures that assessable income derived by a superannuation entity in the capacity of holder of a unit in a trust estate, during the period beginning from the time of the Treasurers Press Release to the end of 2 July 1998, the day on which the legislation was first introduced, is included as special income of the entity if, and only if:
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- there was an arrangement in relation to which some or all of the parties were not dealing with each other at arms length, which relates either to the acquisition of the unit, or to the derivation of the assessable income [Item 4(1)(a)] ; and
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- the amount of that income is higher than might have been expected to have been derived by the entity if those parties had been dealing with each other at arms length in relation to the arrangement. [Item 4(1)(b)]
2.10 The word arrangement has the same meaning as in new subsection 273(8). [Item 4(2)]
Background to the legislation
2.11 The taxation treatment of the income of a superannuation entity is governed by Part IX of the ITAA 1936. In general terms the trustee of a superannuation entity is taxed on the taxable income of the entity at the concessional rate of 15% where there is no special component of the taxable income.
2.12 Where a superannuation entity derives assessable income that is included in the special component of the taxable income of the entity, the trustee of the entity is taxed on that income at the rate of 47%. The assessable income that is included in the special component is termed special income and is income derived from certain types of non-arms length transactions (including the payment of certain private company dividends) that fall within the provisions of section 273 of the ITAA 1936.
2.13 Section 273 is designed to prevent income from being unduly diverted into superannuation entities as a means of sheltering that income from the normal rates of tax applying to other entities, particularly the marginal rates applying to individual taxpayers.
2.14 The ATO has become aware of arrangements which circumvent section 273. Under the arrangements, pre-tax income of a trust (usually a discretionary trust) is distributed to a complying superannuation fund set up for the benefit of the beneficiaries of that trust rather than to the beneficiaries themselves. The effect of the arrangements is that the income is taxed at only 15% as income of the superannuation fund rather than at the marginal rate of tax applicable to other beneficiaries.
2.15 It is doubtful whether subsection 273(4) of the ITAA 1936, which seeks to tax income derived by a superannuation entity from a non-arms length transaction at the non-concessional rate of 47%, would catch these discretionary trust distributions.
Explanation of the amendments
2.16 Item 2 will insert new subsections 273(6)-(8) to tighten subsection 273(4) to close a loophole which allows certain distributions of trust income to superannuation entities made under non-arms length arrangements to be taxed at the concessional rate of 15%. Item 1 makes an amendment to subsection 273(4) as a consequence of the amendments made by Item 2 .
What trust distributions will be treated as special income?
Superannuation entity receives income from a discretionary trust.
2.17 Assessable income that is derived by a superannuation entity, in the capacity of beneficiary of a trust estate, other than through the holding of a fixed entitlement to income, will be regarded as special income of the entity under new subsection 273(6) . That is, new subsection 273(6) will include as special income any assessable income derived by a superannuation entity in the capacity of beneficiary of a discretionary trust.
Example
A husband and wife are principals of a business. A discretionary trust is established to carry on the business, the beneficiaries of which are the principals, other family members and the superannuation fund. A superannuation fund is also established with the principals as the members of the fund. The trustees of both the discretionary trust and the superannuation fund are corporate trustees 100% owned by the principals. This ensures that the husband or wife has effective control over the activities of both the discretionary trust and the superannuation fund.
The trustee of the trust exercises its discretion to distribute an amount of trust income to the trustee of the superannuation fund in preference to the other beneficiaries who would otherwise be taxable on the income at their applicable marginal rate in accordance with Division 6 of Part III of the ITAA 1936. New subsection 273(6) would include any distribution made by the trustee to the superannuation fund as special income of the fund.
Superannuation entity receives income from a fixed trust under non-arms length arrangements
2.18 Assessable income that is derived by a superannuation entity in the capacity of beneficiary of a trust estate with a fixed entitlement to income will be regarded as special income of the entity under new subsection 273(7) if both of the following tests are satisfied:
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- the entity acquired the fixed entitlement under an arrangement, or the income was derived under an arrangement, in relation to which some or all of the parties were not dealing with each other at arms length [new paragraph 273(7)(a)] ; and
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- the amount of that income is higher than might have been expected to have been derived by the entity if those parties had been dealing with each other at arms length in relation to the arrangement [new paragraph 273(7)(b)] .
2.19 New subsection 273(8) provides that for the purposes of new subsection 273(7) , the word arrangement means:
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- any agreement, arrangement, understanding, promise or undertaking, whether express or implied and whether or not enforceable, or intended to be enforceable, by legal proceedings; and
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- any scheme, plan, proposal, action, course of action or course of conduct.
Examples of situations that would be covered by the amendments
At the beginning of the 1998-99 financial year, the trustee of a superannuation fund acquired 20 $1 units in a unit trust. The directors and shareholders of the trustee company of the unit trust are members of the superannuation fund. Each unit conferred a fixed entitlement to distributions of income from the unit trust.
There was a mutual understanding between the parties that subsequent to the acquisition of the units in the unit trust by the superannuation fund, $100,000 would be distributed each year to the unit trust from a discretionary trust of which the unit trust was a beneficiary. Adistribution from the discretionary trust to the unit trust was made prior to the end of the financial year.
Units in the trust were purchased during the financial year by an arms length party for $10,000 each.
At the end of the financial year the trustee of the unit trust resolves to distribute the income of the trust to unit holders.
In these circumstances, the purchase of the units, the subsequent injection of funds from the discretionary trust and the distributions of trust income to the superannuation fund, being within the contemplation of the trustee of the superannuation fund and the trustee of the unit trust (whether or not it is in the contemplation of the trustee of the discretionary trust), would fall within the definition of arrangement in new subsection 273(8) , being an arrangement that relates to the acquisition of a fixed entitlement to the income of the trust.
As the parties are not involved in real bargaining in relation to the arrangement, they are not dealing at arms length with each other in relation to that arrangement. This would be demonstrated by the fact the trustee of the superannuation fund acquired the units in the unit trust for less than market value consideration. The first test in new paragraph 273(7)(a) would be satisfied.
The income of the unit trust has increased as a result of the distribution received from the discretionary trust under an arrangement some of the parties to which were not dealing at arms length. As a result the unit trust has more income available to be distributed to unit holders. If the parties were dealing at arms length no distribution to the unit trust from the discretionary trust could be expected and less income would have been available for distribution to unit holders.
Accordingly, the amount of income derived by the superannuation fund from the arrangement is greater than might have been expected to have been derived by the fund if the parties had been dealing with each other at arms length. The test in new paragraph 273(7)(b) would be satisfied.
The income derived by the superannuation fund will be treated as special income.
On 20 October 1992, the trustee of a superannuation fund acquired 20,000 $10 units in a unit trust. Each unit conferred a fixed entitlement to distributions of income from the unit trust. The members of the superannuation fund are the 100% owners of the corporate trustees of both the superannuation fund and the unit trust. The unit trust paid an arms length distribution to the superannuation fund and other unit holders for the 1993-98 financial years.
During the 1998-99 financial year, the trustees of the superannuation fund, the unit trust and the ABC discretionary trust agree that before the end of the financial year the discretionary trust will distribute $100,000 to the unit trust. The trustee of the discretionary trust is also a corporate trustee 100% owned by the members of the superannuation fund. Also in that year, a private company which the members of the superannuation fund control lends $100,000 interest free to the unit trust. At the end of that financial year the trustee of the unit trust resolves to distribute the income of the trust to the unit holders.
The distribution received by the unit trust from the discretionary trust increases the income of the unit trust, which impacts on the amount available for distribution to unit holders. Therefore, the agreement between the trustee of the unit trust, the trustee of the superannuation fund and the trustee of the discretionary trust would be an arrangement that relates to the income derived by the superannuation fund within the meaning of new subsection 273(8) . As the parties are not involved in real bargaining in relation to the arrangement, they are not dealing at arms length with each other in relation to that arrangement. The test in new paragraph 273(7)(a) would be satisfied.
As the trustee of the unit trust would not have to pay interest on the loan received from the private company the income of the unit trust would be increased, which would have an impact on the amount available for distribution to unit holders. Therefore the arrangement between the trustee of the unit trust and the private company would be an arrangement that relates to the income derived by the superannuation fund within the meaning of new subsection 273(8) . As the parties are not involved in real bargaining in relation to the arrangement, they are not dealing at arms length with each other in relation to that arrangement. The test in new paragraph 273(7)(a) would be satisfied.
The amount of income derived by the superannuation fund from the arrangement is greater than might have been expected to have been derived by the fund if the parties had been dealing with each other at arms length due to:
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- the increase in income of the unit trust as a result of the distribution of income from the discretionary trust to the unit trust (if the parties were dealing at arms length no distribution could be expected); and
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- the increase in the income of the unit trust as a result of the trustee not having to pay interest on the loan from the private company.
The test in new paragraph 273(7)(b) would be satisfied.
The income derived by the superannuation fund will be treated as special income.