Case studies
The following case studies can help you identify and avoid retirement planning schemes:
SMSFs and property development
Eddy and his business partner Michael have operated a successful strata management company for many years. In the past, they considered diversifying into property development, but they are cautious operators. With land prices at an all-time low and market indicators suggesting property prices are on the rise, they decide to take the plunge.
What is the arrangement?
Eddy's friend Paul, who owns Best Building Company (BBC) has made a small fortune through property development, so Eddy goes to him for advice. Paul suggests that Eddy and Michael go into business with him.
Paul explains that the three of them should establish a unit trust. The unit holders will be their respective self-managed super funds (SMSFs). Paul says he has seen his other friends in the building development industry do similar things. The advantage of having their SMSFs invest in the unit trust is that the profits from their property development project can then be distributed to their super fund. Not only will it boost their retirement income significantly within a short period of time without the need to worry about their contribution caps, it also has the added advantage of the income being taxed at 15%.
Paul suggests that Eddy and Michael should also establish a new SMSF for this new business venture instead of using their existing super funds. He tells them it will ensure any risk associated with the business venture will only be limited to any assets in the new fund. Paul assures Eddy that the business venture is low risk, and this is all lawful and other people do it all the time.
Eddy, Michael and Paul establish the EMP Trust. They each establish a new SMSF, being the Paul SMSF, the Eddy SMSF and the Michael SMSF. The three SMSFs subscribe 100 units at $1 each in the EMP Trust. Each of the SMSFs holds one-third of the EMP Trust. None of the SMSFs control the EMP Trust in their own right, however, as Paul is the expert in property development, Eddy and Michael rely entirely on Paul’s knowledge and connection in the industry to manage and make decisions on this property development project. Paul, Eddy and Michael each have their own existing SMSFs that hold the majority of their other retirement savings.
Paul, Eddy and Michael each borrow $4 million from a financial institution, using their personal assets as security. They then each on-lend the $4 million to the EMP Trust at the same interest rate as the financial institution. However, the EMP Trust does not have sufficient assets to provide security for the loan from Paul, Eddy and Michael. If EMP Trust defaults on the loan, the financial burden is ultimately carried by the three individuals. The EMP Trust now has capital of $12 million and it purchases the land for $4 million.
The next month, EMP Trust signs a contract with BBC to build a 10-storey apartment building, and to minimise costs:
- BBC (whose sole shareholder is Paul) will supply any materials and building and construction services at cost
- Eddy and Michael will manage all the paperwork and accounts free of charge
- BBC will be responsible for acquiring all materials and subcontracting.
The apartments are completed in 18 months and sold off giving a profit of $10 million, which the EMP Trust distributes to the Paul SMSF, the Eddy SMSF and the Michael SMSF. The SMSFs then pay 15% of tax on that distribution. All three SMSFs receive a significant return on their initial investment of $300.
What happens as a result?
The SMSFs lodge their tax returns with the ATO. We note the SMSFs’ assets grew significantly over a very short period of time, which raises alarm bells. When audited, the SMSFs have no other assets apart from the units in the unit trust and the trust distribution arising from the property development.
Certain aspects of the arrangement indicate that the parties did not deal with each other at arm's length, including with respect to the supply of materials and services by related parties to the arrangement. Therefore, the EMP Trust distributions are found to be non-arm’s length income under section 295-550 of the Income Tax Assessment Act 1997. We advise that the arrangement may also attract the application of the general anti-avoidance provision of Part IVA of the Income Tax Assessment Act 1936.
We also find that the SMSFs have breached one or more of the following provisions under the Superannuation Industry (Supervision) Act 1993 (SISA):
- sole purpose test under section 62 as the SMSFs were specifically set up to facilitate an arrangement that is designed to inappropriately seek tax concessions, rather than for retirement purposes.
- Section 85 for entering into a scheme that was artificially designed to circumvent the in-house asset rules.
- Section 109 which requires dealings in relation to SMSF investments to be conducted on an arms' length basis.
We revoke the SMSFs’ compliance status and disqualify the trustees, which means the:
- funds will be subject to tax at the highest marginal rate
- trustees' other SMSFs will be affected.
SMSF deriving income from related party property development entities
Tom and Leanne are very experienced in developing small blocks of units and duplexes, having completed numerous developments of this type over the past 10 years. Before getting into property development, Tom worked for many years as a bricklayer, and Leanne as an architect.
Recently a friend of Tom’s tells him about some of the advantages (from a tax perspective) of holding assets in a super fund, particularly once you retire and start a super income stream (pension). Tom and Leanne have an SMSF, but their combined balances only amount to a little over $300,000. Given this and what Tom’s friend tells him, Tom and Leanne discuss ways that they might be able to increase their superannuation balances.
Given their passion for property development and the success they have had in this field in recent years, they would like to use property as a means to increase their super.
One of Tom and Leanne’s companies, TNL Pty Ltd (TNL), holds a large block of land in a leafy inner-city suburb. A number of years ago, TNL obtained council approval for the construction of three semi-detached townhouses but did not proceed with the development. Given the contacts Tom and Leanne have in the building trade, they think that they could make a very good profit from developing the block. Tom wonders if there might be a way their SMSF could be involved in developing this land so it could benefit from the likely substantial profits.
While playing golf at the local club, Leanne’s playing partner suggests that Tom and Leanne get in touch with a lawyer who he says is an expert in structuring and financing development projects involving SMSFs.
Tom and Leanne decide to obtain some advice from this lawyer.
What is the arrangement?
As part of the strategy the lawyer devises, Tom and Leanne are advised to set up a unit trust (the TLP Trust) and use $300,000 of their SMSF’s money to subscribe for all of the units in that trust. The TLP Trust and TNL will then enter into a joint venture to build townhouses on the land owned by TNL. The TLP Trust’s contribution to the joint venture will be $300,000 cash to finance the development. TNL’s contribution will be the land, which is worth approximately $1 million at this time.
To reduce the costs associated with the development, it is suggested that Tom and Leanne do as much of the work on the development as possible, free of charge. Given her architectural qualifications, Leanne is to draw up the plans for the development. Tom, being a bricklayer by trade, is to undertake all of the bricklaying work.
Tom and Leanne’s family trust (the Family Trust) are able to access building materials at significantly discounted rates as they have used the Family Trust in previous developments they have undertaken. Given this, the Family Trust is to be engaged to supply, at cost, the necessary building materials for the development, and engages contractors to undertake the work Tom and Leanne can’t do themselves.
The lawyer suggests that the development profits be split 50/50 between the TLP Trust and TNL, even though the TLP Trust’s contribution to the venture only represents about 23% of the total value contributed to the venture. He says that the disproportionate split of profits between the two venturers is good retirement planning as Tom and Leanne’s super balances in the SMSF will be inflated as a result of the larger distribution.
What happens as a result?
Tom and Leanne think the arrangement sounds very complex and convoluted so they decide to discuss it with their tax agent and their financial planner who had helped them to establish their SMSF and create an investment strategy for the fund.
The financial planner and tax agent, on hearing the proposal, are concerned there may be a number of tax and regulatory issues that could arise under the arrangement. They decide to contact the ATO to check.
We provide advice that income distributed to the SMSF by the TLP Trust will be non-arm’s length income (NALI), and therefore taxed at a significantly higher rate than would otherwise apply:
- The proposed arrangement will constitute a scheme under which the SMSF derives income from the TLP Trust.
- Our published position on non-arm’s length income talks about real bargaining taking place between the parties, but in this case
- there is clear collusion between the parties with one controlling mind, and transactions artificially creating a taxing point within the SMSF
- the TLP trust will receive 50% of the joint venture profits despite only contributing 23% of the capital (and nothing else) to the venture
- significant professional services will be provided by Tom and Leanne at no cost to the venturers; building materials and contract labour will be provided to the venturers at less than commercial rates.
- Due to the non-arm’s length dealings, the distribution the SMSF receives from the TLP trust will be significantly greater than it would have received had the parties to the scheme been dealing with each other at arm’s length.
We further advise that the:
- SMSF’s investment in the TLP Trust will be an in-house asset.
- SMSF's investment in the TLP Trust may be a scheme to avoid the application of subsection 66 (1) of the Superannuation Industry (Supervision) Act 1993 (SISA).
- SMSF may contravene the sole purpose test as it is being maintained for purposes other than those set out in section 62 of the SISA.
The tax agent and financial planner advise them not to proceed as it could result in the:
- distribution from the trust to the SMSF being taxed at the highest marginal rate
- fund being made non-complying and trustees being disqualified.
Tom and Leanne decide not to proceed with the arrangement. They are glad they sought further professional advice from their tax agent and financial planner prior to committing to the arrangement. This has ensured they avoided some serious tax consequences.
Refund of excess non-concessional contributions to reduce taxable components
Gavin and Mary, both in their 50s, decide they want to slow down and travel. They both have long service leave due and Gavin is worried about his health. Gavin feels that as he isn’t getting any younger, they should take their leave and head off on a trip around Australia.
Gavin’s father recently passed away and Gavin, being the only child, inherited $700,000 (which included the house). Gavin considers putting $500,000 into a bank term deposit and $200,000 into a savings account to support them while they are travelling. However, Gavin realises that the interest made would then be taxed at his highest marginal tax rate as his salary is over $180,000 a year. This idea is not appealing.
What is the arrangement?
Gavin’s friend John tells him that he should put all the money into his self-managed super fund (SMSF) because the interest made inside the SMSF will be taxed at the concessional rate of 15%. John also tells Gavin not to worry if it is over the contribution limits as the ATO will just send him a letter to withdraw the excess so there won’t be any problems. John goes on to say, that when Gavin withdraws the money, he can reduce the taxable component of his superannuation interest and he will save later on tax. John assures Gavin that this arrangement is above board as there is currently no legislation requiring that the excess funds must be withdrawn from the same non-concessional contribution (NCC) funds that were put into the SMSF.
Gavin knows the $700,000 will exceed the NCC limit (including the ‘bring forward’ provisions) so he decides to contact the ATO for advice. We advise Gavin of the following concerns on this arrangement:
- It is an attempt to reduce the taxable component of the super interest and ultimately lower the amount of tax payable when the super benefit is eventually paid.
- While super benefits taken by a member over 60 years old are not part of the member’s assessable income, there are concerns with this arrangement when
- the member withdraws super benefits before turning 60, as the taxable components are included in the member's assessable income
- in the case of estate planning where the super benefit is paid to a non-dependent upon the member’s death, the taxable component (concessional contribution) will be taxed at the beneficiary's marginal tax rate.
- If Gavin goes ahead and deliberately contributes in excess of his cap, and then withdraws the excess resulting in a reduction of his taxable component, he could be subject to the anti-avoidance rules in Part IVA of the Income Tax Assessment Act 1936.
What happens as a result?
Mary tells Gavin she is worried about withdrawing the excess. She thinks his friend is not telling the truth as he isn’t a professional advisor and it sounds like a scheme to avoid paying the correct amount of tax. After considering the advice of the ATO, Gavin decides to only contribute up to his available NCC limit of $300,000 (including the ‘bring-forward’ provisions) which keeps him from having excess contributions.
Granting legal life interest over commercial property to SMSFs
Brett is a qualified auto mechanic and has been successful in operating his own business. The business has grown rapidly over the years allowing Brett to diversify into commercial property investment. Brett and his wife Michelle have been planning for their retirement and have in the past sought the professional advice of an SMSF advisor. Now they only have a few more years to work, they want to seek further advice on the best way to maximise their retirement nest egg and guarantee them a comfortable future.
What is the arrangement?
Brett does some research and also asks his friends what they are doing. His friends tell him about a deed granting life estate interest in which you sign over your property to your SMSF. Brett looks further into this. The deed will give his SMSF a life interest over the commercial property. The SMSF, as holder of the life interest, is entitled to exclusive use of the commercial property while the person called the ‘life in being’ is alive. The 'life in being' is a specified individual, commonly the owner of the property, a member of the SMSF or another nominated person.
The SMSF, as the holder of the life interest, will be entitled to the rental income from the commercial property and then return the income to the SMSF members as a pension or reinvest it to increase the members’ account balances. When either the ‘life in being’ dies or the life interest comes to an end by agreement from both parties, the full rights (use and income) returns to the title holder or their deceased estate.
Brett thinks the plan sounds sensible. He thinks they can even extend the arrangement to their residential rental properties. The SMSF does not have to pay much for the rights to the commercial property as he already owns it. He explains to Michelle by diverting rental income to an SMSF:
- the income will be concessionally taxed (or even treated as exempt current pension income if he or Michelle commence a pension)
- the tax on their taxable income will be reduced
- they can still claim deductions for the property on their own income tax returns
- they will pay less capital gains tax compared to if they sell the property outright to their SMSF and can also save on stamp duty costs.
Michelle, being the more cautious of the two, suggests that Brett seeks advice from a professional advisor before entering into the arrangement.
What happens as a result?
Brett contacts his trusted SMSF advisor to ask if this is a good idea. The advisor asks Brett how his SMSF is planning on paying for the life interests and becomes concerned when Brett says he will only pay a small amount by way of the cash in his fund. Brett also says that his mates told him that his SMSF could get a loan if necessary to pay for the life interest in the commercial property if he has to.
The advisor becomes concerned that this arrangement will be regarded as tax avoidance. After checking the Super Scheme Smart website, the advisor informs Brett of ATO’s concerns that:
- These arrangements are an attempt to divert rental income from an individual to an SMSF where it is concessionally taxed or treated as exempt current pension income.
- There may be a breach of provisions relating to acquiring assets from related parties where the asset subject to the life interest is not commercial property (section 66 of the Superannuation Industry (Supervision) Act 1993 (SISA), so residential rental properties can’t be considered for granting life interests).
- The arrangement is often only considered due to the close relationship between the parties involved so the non-arm’s length income provision may apply to the rental income received by the SMSF.
- The value given to the life interest may not be fair market value and therefore the asset may be undervalued, which causes issues with
- underestimating capital gain
- transfer balance cap calculations if either Brett or Michelle commence a pension
- Michelle and Brett inadvertently exceeding their non-concessional contributions caps when the property is revalued correctly.
- While the value of the life interest is only a proportion of the property’s value, the SMSF has full access to the commercial property and 100% of the income it generates, which is not reflective of a true commercial relationship.
- The arrangement could be seen as an attempt to avoid exceeding contribution and transfer balance caps that would otherwise occur if the entire asset was contributed (rather than just the value of the life interest).
- Michelle and Brett may avoid the non-concessional contribution caps because only a percentage of the value of the commercial property is contributed to the SMSF yet the SMSF has full access to the commercial property and 100% of the income it generates.
- Michelle and Brett planned to continue to claim the property deductions as their own, while the income is being received by the SMSF, which might not be allowable under the income tax law.
- If the SMSF borrows to buy the life interest, it must satisfy the limited recourse borrowing conditions in section 67A of the SISA.
On the advice of his SMSF advisor and understanding the ATO’s position on these arrangements, Brett decides not to proceed with the arrangement. He now understands that he cannot just give his properties to his SMSF or use his SMSF to get a loan to pay for the properties unless he looks carefully at the rules.
Dividend stripping
Marek is a savvy businessman who operates a successful privately-owned family business. He and his wife Halina are the only shareholders in the company, which has significant accumulated profits that can be paid out as franked dividends. As smart investors, Marek and Halina also manage an extensive investment portfolio through their own self-managed super fund (SMSF).
Both Marek and Halina are in their 50s, and are looking to make the move into retirement within the next few years to travel and spend more time with their grandchildren. As such, retirement planning is high on their agenda.
What is the scheme?
Marek hears of a scheme to reduce his tax burden and seeks the advice of a scheme promoter.
The scheme promoter advises Marek to transfer his company shares to his SMSF before the company pays out any franked dividends. That way, Marek can avoid the income tax that would be payable had Marek and his wife receive the franked dividends directly.
Marek decides to proceed with the scheme as a way of minimising his tax liability and to facilitate the refund of franking credits to his SMSF.
What happens as a result?
The scheme comes up on our radar and we advise Marek he will be audited for the current financial year.
Marek is unconcerned, believing the scheme to be above board and in accordance with the tax and super laws.
During the audit we determine that arrangements of this nature:
- may constitute an anti-avoidance arrangement, designed to provide a franking credit benefit for Marek through his SMSF
- direct franked dividends to the SMSF as part of what may be a dividend stripping transaction that may give rise to a non-arm’s length income for the SMSF.
We inform Marek that we will investigate the arrangement further and suggest that he cooperate fully with our requirements. Marek decides to seek independent advice from a trusted and reputable professional, as well as consulting our website.
He determines that if he is found to have participated in a tax avoidance scheme, he risks losing part of his retirement nest egg and can incur severe penalties, including his rights as a trustee to manage and operate his SMSF.
To protect his nest egg, Marek works cooperatively with us, understanding that this approach will produce the best outcome.
Non-arm’s length limited recourse borrowing arrangements
David and Claire are keen property investors and have been quite successful in buying and selling properties over the years. Through a property investment club in which they are members, they learn that 15% concessional tax rates apply to income earned from investment properties (held for rent) purchased and maintained through a self-managed super fund (SMSF).
What is the scheme?
Doug, a fellow member of the property investment club, contacts David and Claire and explains he is an expert who has helped many members of the club buy investment properties through an SMSF.
David and Claire establish an SMSF and roll over their retirement benefits into the new fund. However, the money they roll over isn’t enough to purchase the investment property. On the advice of Doug, David and Claire approach their bank for a loan to buy a rental property through their SMSF using a limited recourse borrowing arrangement (LRBA), which limits the SMSF's repayment risk on the loan to the recoverable value of the investment property.
Their bank is happy to approve the loan, however David and Claire are unhappy with the terms of the loan. Doug advises that given they have the necessary money held outside of superannuation they could lend this money to their super fund by setting up an LRBA, instead of using a bank.
Under the LRBA David and Claire loan the SMSF 100% of the principal over a 15-year term; and the trustee of the SMSF is required to make periodic (monthly) repayments of the loan principal with the first repayment made five years after the loan is established the interest rate applied to the loan was zero.
What happens as a result?
David and Claire’s accountant prepares their individual and SMSF tax returns each year. The accountant informs them he has some concerns with this LRBA under tax and super laws, and that he will consult with the ATO for further clarification.
We advise that the arrangement is a non-arm’s length LRBA. Accordingly, all income from the asset will be considered to be non-arm’s length income; and as a consequence all of the rental income received by the SMSF will be taxed at the highest marginal rate. The non-arm's length interest expenditure incurred under the LRBA will also result in any capital gain that might arise from a subsequent capital gains tax (CGT) event happening in relation to the property (such as a disposal of the property) being NALI and taxed at the highest marginal rate.
David and Claire decide to refinance their rental property investment through a bank and dissolve the non-arm’s length LRBA (avoiding the highest marginal rate) with future rental income taxed at the SMSF concessional rate.
David and Claire agree that in the future, they will always seek a second opinion from an independent financial advisor or refer to the ATO website for further tax and super guidance.
Personal services income
John is a locum doctor, working as a sole trader. He invoices the various medical practices that he locums using his personal ABN.
John and his wife have for many years operated their own self-managed super fund (SMSF).
As John approaches retirement age, he wants to get financial advice on how best to maximise his income for retirement.
What is the scheme?
John talks with a friend about wanting a better plan for his retirement. His friend tells him that he’s heard of a great scheme and puts him in touch with the promoter.
The promoter suggests that John sets up a unit trust, with John's SMSF as a unitholder, and that his clients make payment for his services to the unit trust. The unit trust distributes the income earned by John (in part or whole) to his SMSF as a 'return on the SMSF's investment'.
As a trustee of the SMSF, and being over the preservation age, John treats the income as subject to a concessional rate of tax or exempt from tax (for supporting pensions).
What happens as a result?
John is quite sceptical; the arrangement seems quite convoluted and sounds almost too good to be true.
He seeks a second opinion with his own tax agent who is registered with the Tax Practitioners Board to get some independent advice.
After checking out our Super Scheme Smart website the tax agent informs John that:
- there is no guarantee that this type of arrangement will reduce his income tax and the income may still be included in his assessable income as personal services income
- the amounts received by the SMSF may constitute non-arm’s length income of the SMSF such that the income is not eligible to be concessionally taxed, and is not tax exempt because it is supporting pensions and is instead subject to tax at the highest marginal rate.
The tax agent warns John that such arrangements are illegal. He warns that 'schemes' of this nature are on the ATO’s radar and explains to John that he may incur severe penalties if he proceeds, including a financial loss, and the loss of the right to manage and operate his own SMSF.
On the advice of his trusted tax agent, John decides not to proceed given the potential for personal and financial risk. He also decides to report the promoter to the ATO. John is thankful that he has had the foresight to seek a second opinion and hopes others faced in a similar predicament do the same.
Liquidating an SMSF to avoid paying tax liabilities
Tiffany and Bjorn have operated a successful family business and have an SMSF, being the T&B SMSF, with a corporate trustee (Trustee Co). The ATO commences an audit of T&B SMSF's activities and there are potential tax liabilities arising from the T&B SMSF receiving non-arm's length income.
What is the scheme?
A promoter approaches Tiffany and Bjorn and suggests that they set up a new SMSF to roll over the fund balance from the T&B SMSF into the new SMSF. They then liquidate Trustee Co in an attempt to avoid paying the potential tax liabilities.
What happens as a result?
Tiffany and Bjorn are sceptical and seek a second opinion from a tax agent who is registered with the Tax Practitioners Board to get some independent advice. The tax agent warns Tiffany and Bjorn that such arrangements aimed at avoiding paying tax liabilities are on the ATO's radar, and Tiffany and Bjorn may face civil and criminal actions if they proceed with this arrangement.
On the advice of the tax agent, Tiffany and Bjorn decide not to proceed with the arrangement and they report the promoter to the ATO.
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