Meeting great expectations - the reality behind SMSFs

Address by Stuart Forsyth, Assistant Commissioner, Superannuation, ATO
to the Association of Independent Retirees Conference 2012
Tuesday 13 November, Bayview Eden Hotel, Melbourne

Introduction

I'd like to thank you for giving me the opportunity to speak at your conference today. As you know the theme of your conference is 'Great Expectations - Life in Retirement'.

At the SMSF Professionals' Association of Australia National Conference in 2010, Jeremy Cooper said that 'the ultimate vision for SMSFs should be as a leading superannuation vehicle' and one that is 'well-placed to achieve net investment returns that are at least as good as other sectors'. With the rapid growth of SMSFs, it seems many Australians want to achieve these great expectations.

I'll be going through a range of topics and issues relevant to you as trustees, including some of your responsibilities as well as taking a closer look at the nature of an SMSF. I'll also discuss the changing landscape of the SMSF industry as more funds are entering the pension phase. From a compliance perspective, the taxation of SMSFs can be complex and I'll discuss some of the areas around exempt current pension income, non-arm's length income and anti-detriment payments as well as provide an update on the super reforms and how the new measures may impact you. I'll run through some of our compliance focus areas for this financial year and finish off with a couple of thoughts I have on the Association of Independent Retirees and the SMSF sector.

These thoughts are based on the fact that over five years ago your organisation and mine started an active regular dialogue. One of the main reasons we were keen to build that relationship was the difficulty we have in obtaining trustee perspectives. There are plenty of voices on super and SMSFs but the trustees of SMSFs do not have a clear voice.

Looking back on our work with AIR I would like to thank you for your forthright engagement and the trustee insight you have provided including through assisting us to user test new products.

Nature of an SMSF

It is no secret that SMSFs are a growing market. What might surprise you is how quickly they're growing.

As at September 2012, there were over 488,000 SMSFs, holding $458 billion in assets, run by over 932,000 members. We took over the regulation of just over 187,000 SMSFs from APRA in 1999 and to September 2012, we've seen a 161% growth in the number of funds.

The growing number of SMSFs underlines the need for the trustees running these funds to understand their responsibilities and obligations.

2009-10 and 2010-11 statistics

We continue to work on improving the quality of information available about the SMSF sector. In April we published our latest statistical overview for the 2009-10 year. This is the second in an annual series of publications providing key SMSF statistics and we expect to release the overview based on 2011 data soon. Our early analysis shows for the 2011 year a return on assets of 7.7% for SMSF's that is only slightly lower than APRA funds at 7.8%. SMSFs had an average rate of return of 3.75% over the five years 2007 to 2011.

Know your responsibilities

As an SMSF trustee, you are ultimately responsible for running your SMSF. It is important you understand your duties, responsibilities and obligations. While you do have the control of running the fund, you also take the risk that is associated with running it.

As a trustee of an SMSF, you need to act according to the following:

• your fund's trust deed
• the provisions of super law, including the
• Superannuation Industry (Supervision) Act 1993
• Superannuation Industry (Supervision) Regulations 1994
• the Income Tax Assessment Act 1997 (ITAA 1997)
• the Tax Administration Act 1953 (TAA 1953)
• the Corporations Act 2001
• other general rules, such as those imposed under other tax and trust law.

In addition, new measures have also been introduced and I will go through these later.

The concept of a fund

Your responsibilities to the fund carry on in retirement and beyond. The fund is a separate entity from its trustees and should be treated as such. We find this point is often overlooked and I want to stress the importance of this concept to you today. On the death of a trustee, there is always the question of whether or not the fund will be wound up, or left to continue.

While the idea of an SMSF being an indefinite inter-generational wealth vehicle sounds great, the practical reality is that this would depend largely on two factors:

• the estate plan of the deceased
• the willingness and ability of the remaining (or new) trustees to continue to perform the trustee role.

For the SMSF to safely continue, the remaining (or new) trustees need to be up to the responsibilities of trusteeship.

Following on from this concept, the fund keeps going even when you can't. As a trustee, you may reach a point where you want to exit the SMSF. For some people, the ongoing paperwork and investment management becomes a task that they just don't want to deal with anymore. Others who have had poor results from their investment management sometimes decide it's best to hand it back to a fund manager and roll over their super into a retail or industry super fund. Whatever the reason, there are several options available to you to end your involvement with your SMSF.

You can choose to wind up the fund and return to a large APRA-regulated fund or in some cases pay out the balance. This involves

• notifying the ATO within 28 days
• ensuring that the fund has no assets left
• conducting a final audit of the fund
• completing your reporting responsibilities.

However, if the fund hasn't met the conditions of release, the money will have to stay in the system.

Another option is to appoint a licensed trustee and move to becoming a small APRA fund, or bring in another trustee to manage the SMSF for you. You will need to let the ATO know by completing a change of details form within 28 days of a change taking place; any new trustees also need to complete a trustee declaration form.

All of this highlights the important point that the SMSF is a separate entity from its trustees and should be treated as such.

Pensions

There has been growing interest in this area as more SMSFs enter the pension phase and members consider how this will affect their income tax and reporting obligations.

Here are some quick stats:

• for the year ended 30 June 2010, 66% of SMSFs reported they were solely in the accumulation phase, whereas the remainder reported they were making pension payments to some or all members
• analysis of the three years between June 2008 and June 2010 shows 7.9% of SMSFs who reported they were solely in the accumulation phase have shifted into the pension phase
• on average, those SMSFs which started pension payments in 2010 had been established for at least five years; over 45% were over five years old, about 30% were under two years old and almost 14% were operating in their first year
• the average age that SMSFs enter the pension phase has remained relatively stable. Analysis shows however, that from 2008 to 2010 there was a clear shift towards SMSFs starting to pay pensions in their first year of existence. Refer to Self managed superannuation funds: A statistical overview 2009-10.

These statistics show a growing trend in trustees moving to pension phase and this has definitely caught our attention.

Exempt current pension income

We've found that trustees often find some of the areas involving income tax confusing, so I'll take some time to go over the key concepts.

Your SMSF can claim an exemption from income tax for earnings and capital gains from assets that are supporting the payment of a pension to a member. This is called exempt current pension income (ECPI) and does not include assessable contributions or non-arm's length income.

You can claim the tax exemption in your SMSF annual return once your SMSF begins paying pensions. However, your SMSF is not automatically entitled to the exemption and you'll need to take steps before starting payment of the pension, including ensuring that all assets are re-valued to their current market value.

As a trustee, we'd like to remind you to:

• meet the requirements for calculating ECPI (for example, if using the segregated method, you must set aside certain assets so that the income from these can be identified as having the sole purpose of paying a pension)
• get an actuarial certificate (if you need to) before lodging your annual return as the ECPI claim may be disallowed if it isn't present
• re-value the SMSF's assets to their current market value before starting the pension
• comply with the minimum payment standards.

Over the past few years we've noticed a significant increase in tax losses carried forward. While some of this can be attributed to current economic conditions, we're seeing a significant number of funds in partial pension phase offsetting other income against these losses. The amount of the tax losses should be reduced by the amount of the net ECPI before offsetting against assessable income of the SMSF or carried forward to the next financial year.

You may also be aware from the media that we've issued Draft Taxation Ruling TR 2011/D3 Income tax: when a superannuation income stream commences and ceases.

This ruling clarifies the need to meet the minimum payment standard requirements in order to be entitled to ECPI. The ATO's long-held position is that a pension ceases for income tax purposes if any of the requirements of the SIS Regulations relating to the payment of the pension are not met in an income year. The other issue addressed by this draft ruling is the ability to continue to claim ECPI where a member receiving a pension dies. The pension is taken to stop as soon as the member dies unless the deceased member's dependant beneficiary is automatically entitled to receive it.

Although the finalisation of the draft ruling has been delayed, we're exploring the use of the Commissioner's administrative powers to overcome some of the issues identified by industry throughout the consultation process. As a result, we intend to publish a set of question and answer fact sheets from the perspective of an SMSF trustee to complement the final ruling.

In the Mid Year Economic and Fiscal Outlook released on 22 October, the government announced that it will amend the law to allow the tax exemption for earnings on assets supporting superannuation pensions to continue following the death of a fund member in the pension phase until the deceased member's benefits have been paid out of the fund. This change is proposed to commence from 1 July 2012. This change will benefit beneficiaries of deceased estates by allowing super fund trustees to dispose of pension assets on a tax-free basis to fund the payment of death benefits.

Non-arm's length income

Moving on to other areas of income tax, it appears that there is still confusion around non-arm's length income (NALI). We've found that some SMSFs are still not reporting this income at the correct label and are therefore not paying the correct amount of tax.

You can expect to see more activity from us in this area, including more litigation. In light of recent decisions in our favour, we encourage trustees to:

• ensure that all SMSF transactions are at arm's length
• check that any previous SMSF transactions (that are still giving rise to income) were at arm's length
• remember that a transaction can still be determined as not being at arm's length even if the other party is not related.

For more information on our view on what we consider to be non-arm's length income, you can refer to Taxation Ruling 2006/7.

Anti-detriment payments

There continues to be some discussion in the industry about whether SMSFs can claim a deduction for anti-detriment payments. The answer is they can. Anti-detriment payments are lump sums which can be made on the death of a member to an eligible spouse or dependant. The payment increases the deceased member's lump-sum benefit to return the impact of tax withheld while the member's benefit was accumulating.

Typically the fund sets aside amounts of SMSF earnings, uses the proceeds of an insurance policy or uses other cash on hand within the fund to make these payments.

Changes to the SMSF annual return

We try to make it as easy as possible for you to comply. We publish a range of materials, both on our website and through free subscription services such as SMSF News, to help you stay informed and up to date.

One of the key messages we're trying to communicate to you as SMSF trustees is to lodge your annual return on time. The majority of funds do the right thing and lodge on time but a number lodge late or not at all. We know that many of these SMSFs remain active but despite a number of reminder notices from us, they've still not lodged their annual return. This obligation is one of the basic responsibilities of SMSF trustees. On-time lodgment rates are at 74% while the overall rate is just over 92%. This is simply not good enough.

Based on our research and trustee feedback, we've made changes to the SMSF annual return to make it easier to comply.

To ensure your annual return lodgment isn't rejected, you'll need to complete the return in its entirety, including approved auditor details. Furthermore, from 1 July 2012, the 2012 SMSF annual return will not be processed if there are no assets in the fund, unless it's the fund's final return.

Other substantial changes include:

• making the SMSF auditor number (SAN) mandatory on the annual return (this only needs to be filled out if your auditor is registered at the time of completing the return)
• moving the ECPI label from the deductions section of the return to the income section
• splitting 'management and administration' into two separate items
• re-arranging the calculation statement to reflect the operation of the legislation and to ensure fund credits and offsets are correctly allocated.
• showing contributions from non-complying funds as well as re-naming the 'other family and friends contribution' label to 'other third party contributions'
• 'Derivatives and Instalment warrants' is now shown as 'Limited recourse borrowing arrangements' and 'Artwork, collectables, metal and jewels' is now shown as 'Collectables and other personal use assets' in the 'assets and liabilities' section of the form
• adding an additional question in the regulatory section which requires a fund to advise of any exempt assets acquired from a related party and the dollar amount of these assets.

These changes help us find opportunities to streamline some elements of the return for funds that are in full pension phase.

Over time, we aim to improve both data collection and analysis about the SMSF sector. The government has tasked us to produce statistics that will provide a greater understanding of the SMSF sector. This includes looking at maximising the comparability of SMSF statistical information with the information published by APRA in relation to the sector.

Super reform

The Cooper review produced a number of recommendations that the government has accepted. A number of these measures relate to SMSFs and aim to mitigate risks. While it does mean additional obligations for you, the reforms will strengthen the framework in which SMSFs operate.

Changes around collectables and personal use assets, regulations for market valuation requirements, sanctions for separation of assets breaches, and requiring trustees to consider insurance for SMSF members have been introduced. Legislation has been introduced for SMSF auditor registration.

New requirements

So what are some of the changes that will affect you as a trustee?

You are now required to:

• review your fund's investment strategy on a regular basis to take into account the changing circumstances of the fund and its members. This does not mean you need to change your strategy every time you review it but you need to ensure you maintain an awareness of the investment landscape and make adjustments to the strategy to accommodate any changes to your members' circumstances. This review may be documented in the minutes of the meetings held during the year as evidence that you have complied with the requirement
• consider insurance for fund members as part of the investment strategy of your fund. The type and level of insurance cover that members might require should take into account their personal circumstances. Again, documenting these decisions in the fund's investment strategy or minutes of trustee meetings will provide evidence that this requirement has been complied with
• value the fund's assets at market value for the purposes of preparing financial accounts and statements of the fund. As it is already common practice to use market value, this is not a major change for most funds. This obligation applies to the financial accounts and statement for the 2012-13 and later years of income, meaning the first time you need to comply with this requirement is when determining the market value of the assets as at 30 June 2013. We have published valuation guidelines for trustees on our website to help you and your advisors with this and other valuation obligations imposed on you by the law.

Finally, as a trustee, you should already be aware that you need to keep money and other assets of the fund separate from any money or assets held by you personally or by a standard employer-sponsor or an associated standard employer-sponsor. Because this was previously a covenant and therefore part of the governing rules of the fund, the law did not give the ATO an enforcement role. This requirement is now a prescribed operating standard, so we are now able to better enforce compliance with it. We'll be publishing guidelines to support trustees in complying with this measure.

Differentiated compliance treatments

The government has proposed new powers to provide the ATO with additional options and greater flexibility to deal with non-complying SMSF trustees. These changes are expected to apply to contraventions that occur after 1 July 2013 and will allow the ATO to:

• apply administrative penalties for contraventions of super legislation
• direct trustees to rectify contraventions
• direct trustees to undertake education.

For example, if we feel that a lack of knowledge and understanding has contributed to a breach, we may direct the trustees to undertake education. Of course, serious breaches or continued contraventions may require more serious penalties such as making the fund non-complying, disqualifying trustees or instigating civil or criminal prosecution action.

Transactions involving related parties

The government has proposed that from 1 July 2013, the acquisitions and disposals of assets between SMSFs and related parties are to be conducted through an underlying market. If an underlying market doesn't exist, acquisitions and disposals must be supported by a valuation from a qualified independent valuer. As I mentioned before, you might find our valuation guideline for trustees on our website to be a very useful source of information in helping you meet these obligations if they come into effect.

Auditor registration

The government has also announced that SMSF auditors will need to be registered and meet specific competency requirements to carry out their work.

Registration process will commence from 31 January 2013 and ASIC will be responsible for developing and maintaining the registration system. From 1 July 2013, auditors will be required to be registered with ASIC to conduct SMSF audits. Registration will ensure that SMSF auditors have a minimum standard of competency and knowledge of relevant laws to be able to detect and report contraventions by SMSF trustees.

So what does this mean for you? Make sure that your auditor is registered with ASIC before they audit your fund next year.

Future changes

Our work isn't done yet. There are still more changes to come in the following years.

The SuperStream enhancements, changes to the 'back office' of the super system, will improve the infrastructure of the system and reduce data quality issues. We'll also be looking at the integrity of the registration and rollover processes for SMSFs and have measures under development to further support these. These include proof of identity requirements, changes to the registration requirements for SMSF bank accounts and capturing SMSF advisor details.

As I've said, a lot of changes have been made and there are more to come. It's important that you understand and apply the new rules.

Compliance program

Moving on to the 2012-13 Compliance Program, I'll give you a brief overview of some of the focus areas.

As a trustee, you need to:

• make sure you (especially if you're a new trustee) can operate your SMSF
• make sure you lodge your annual returns on time and also, in the case of new funds, to ensure they're entitled to receive their notice of compliance
• look out for irregularities in ECPI and NALI transactions
• avoid re-reporting contributions to avoid ECT, and comply with ECT release authorities
• know of any breaches reported to us by approved auditors.

One thing to keep in mind is that we're not out to catch you on every error in your returns. Our compliance activities are directed towards those who do not want to comply, who are consciously engaging in incorrect behaviour. For more information on our areas of concern, have a look at our Compliance Program for 2012-13.

AIR and the SMSF sector

As members of the Association of Independent Retirees, you are among approximately 10,000 self-funded retirees. Many of you are trustees of an SMSF. To me, this represents a large number of trustees with a shared goal and vision.

AIR has already been a voice for trustees but more could be done. In many consultation processes it is advisers, auditors, large funds and administrators who are represented. There is scope here for members to get involved, understand the system and become a voice for trustees.

Closing

We all hold great expectations for SMSFs and for the industry as a whole. In order for us to reach the lofty vision set out by Jeremy Cooper, trustees will need to continue to embrace the responsibility of running an SMSF and all that goes into it. The ATO considers you to be separate from your fund. You are responsible for running the fund and this entails a certain level of knowledge, competence and commitment and I hope I have provided some clarity on where you stand as a trustee.

I'm now happy to take questions.