NALI/NALE, Property

Undervalued trust units a NALI risk

trust NALI

SMSFs purchasing low value stakes in interposed entities to develop property will need to prove they were at market value to avoid breaching NALI provisions.

SMSF members purchasing low value stakes in interposed entities that will be used to develop a property are likely to find the arrangement will be considered as being on non-commercial terms exposing any income received by the fund to the non-arm’s length income (NALI) rules.

DBA Lawyers special counsel Bryce Figot said the ATO has issued a warning about the need for any relationship within a special purpose vehicle involved in developing an asset, such as property, to be at arm’s length and this includes the stake an SMSF, or its related entities, took in that vehicle.

Speaking during a recent webinar, Figot pointed to an example provided by the ATO of two SMSF’s setting up an interposed company (XYZ Interposed Co) and taking a 50 per cent stake in that company for $1 per share for a total initial payment per fund of $50.

Following this XYZ Interposed Co then enters into a building development project via a second company (New Interposed Co) whose shares are issued to XYZ Interposed Co on a non-arm’s length nominal basis.

Given this Figot questioned how the shares issued in New Interposed Co should be viewed in regards to NALI and how would that price impact the stakes held by the two SMSFs?

“Assuming upon incorporation, New Interposed Co has no assets with just paid up share capital of 100 ordinary shares at $1 each, does that mean the market value of the shares is only $1 times 100 or is it more than just $1 times 100?” Figot asked.

He referred to the case of GYNW and Commissioner of Taxation (2019) where the Administrative Appeals Tribunal did not accept the view tht only cash flow was relevant in determining the value of a business while the High Court noted in Clifford’s Case (1947) that a purchaser would not buy shares in a company with a view to closing it down but would consider the probable profit the company may be expected to make in the future.

“So the more important item is the determination of the probable profit which the company may reasonably be expected to make in the future and it is clear these two SMSFs are not going through the formality of buying 50 per stakes in the company to wind it up and get their $50 back.

“They are doing it because they have a plan and there is some probable profit which they reasonably expect to make in the future.

“Importantly in Tax Alert TA 2023/2 the Commissioner says if shares are not purchased at an arm’s length price, this may give rise to non-arms length income and it cites the above cases.“

“It doesn’t expressly say that you can’t use that $1 methodology but how are you going to look if the funds have paid some nominal amount now and then in the future received hundreds of thousands or millions of dollars. You’re going to have a difficult time because it is a difficult to defend set of facts.”

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