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  • The ATO and SMSFs: an update

    Matthew Bambrick, Assistant Commissioner,
    SMSF Segment, Superannuation

    Address to the Tax Institute, 12th Annual Superannuation Intensive Conference
    Sheraton on the Park, Sydney, 12 March 2015

    Introduction

    Thank you for inviting me to speak to you today. I always value the opportunity to listen to and engage with stakeholders. Over the past year, working with stakeholders and industry, we’ve made great progress in strengthening the SMSF sector to ensure that it achieves its sole purpose: to grow and protect retirement incomes.

    Ninety-nine per cent of all Australian super funds are SMSFs and they hold 30 per cent of the $1.9 trillion of total super industry assets. For the first time, in 2013, the median age of members in newly established funds was under 50 (with 36 per cent under 45).

    But of critical importance is retirement and the number of members now shifting to benefits phase. Forty two per cent of SMSF members are 60 and over and while the majority of SMSFs are in the accumulation phase, the number of funds reporting exempt current pension income (ECPI) is growing. Starting to pay pensions brings new challenges for trustees such as calculating and making minimum pension payments, managing assets on a segregated or unsegregated basis, calculating ECPI and correctly claiming expenses. One of the key things I want to talk about today is our technical guidance around ECPI.

    I’m also going to cover two other topics that have received considerable attention lately: non-commercial limited recourse borrowing arrangements and other loan arrangements that contravene super laws.

    But first I want to recap the highlights of the past year and mention some of the new and diverse channels we’ve been using to communicate with our audiences.

    State of play and contemporary services

    From July last year we’ve managed SMSF compliance in a more targeted manner and administrative penalties and direction powers now better match compliance treatments. Our comprehensive risk models detect potential problems with new registrations and new members as well as concerns with established SMSFs. The models help us determine appropriate compliance treatments and cover 80 per cent of our compliance cases (the other 20 per cent being mainly risk-referral type cases and income tax cases such as dividend stripping, dividend washing and ECPI).

    Due to improved data sources and more confidence in SMSF auditors, we can also rely more on our risk models. Auditor registration with ASIC has been operating successfully for over a year and auditor numbers continue to reduce as the smaller players leave the system. We expect that those who remain will produce higher quality audits because they’re better focused on SMSFs.

    During 2014, in line with feedback from clients and industry, we focussed on improving our service delivery for SMSFs by developing new and improved ways to communicate and connect with you. We’ve reworked web and app content, launched SMSF assist and 22 educational videos (these videos have been viewed over 250,000 times and there are more to come). We’ve hosted SMSF professionals webinars and continued our strong connections with other regulatory bodies, professional associations and industry professionals, both formally and informally. We’re improving our methods and timeliness of communication. SMSF News is now issued every two months and includes more regular online updates, Q&As sourced from the public and real-world case studies. We’ve also reduced cycle times for some of our compliance work.

    As we further develop and expand our webinar program, we’re gradually transitioning away from multiple ‘one-off’ presentations. Webinars offer much needed flexibility for both presenters and participants and I’d be interested later to hear your views on this channel. You can access all our SMSF professionals webinars at www.ato.gov.au/SMSFwebinars

    Looking ahead, we’ll be expanding our online services, reducing the complexity of annual independent audits, creating more education products for trustees and working with software developers to improve administration products and streamline processes.

    Exempt current pension income (ECPI)

    For the 2012-13 income year just over 204,000 SMSFs (or 46 per cent of those that lodged) reported some portion of their income as ECPI. This equates to $16.8 billion of ECPI, which is $16.8 billion of SMSF income exempt from income tax.

    There were one million SMSF members as at 30 June 2014, and approximately 39 per cent reported receiving pension payments, with pension payments worth $19.1 billion. About 8.5 per cent of SMSF members receive transition-to-retirement payments.

    Given the ages of existing SMSF members, we expect a further 250,000 will be eligible to receive a pension sometime in the next 10 years. So we expect ECPI claims to continue to rise. As we’re already seeing a few issues I’d like to provide some guidance around calculating and reporting ECPI:

    • to be exempt from an actuarial certificate, you must use the segregated method for the entire income year. The number of funds which start a pension part way through the year and rely on this actuarial exemption remains high. This creates a problem if these funds face compliance action because of the requirement to obtain an actuarial certificate before lodging the annual return in order to be entitled to claim ECPI
    • where all fund members receive a pension for the entire year of income and the combined account balances of the pensions equals the market value of the fund's total assets, the assets of the fund meet the requirement of being 'segregated' (as their sole purpose is paying super income stream benefits). In this situation, the SMSF isn’t required to identify individual assets as being dedicated to funding a super income stream benefit. Accordingly, as the assets are ‘segregated current pension assets’ any income from these will be exempt income and any capital gain or loss in relation to a segregated current pension asset must be disregarded
    • declaring ECPI is not ‘optional’. What I mean is that the income of an SMSF is either assessable or exempt. A trustee cannot re-characterise the income simply by not obtaining an actuarial certificate. Therefore, where a fund is using the unsegregated method, an actuarial certificate is required to determine the portion of the fund’s income considered as exempt income. To promote correct reporting, we’ve been making changes to the SAR since 2012 and ECPI is no longer reported in the ‘deductions’ section. We’re now looking at what additional guidance we can offer to continue to shift any misconceptions that ECPI is something that a trustee elects to ‘claim’ similar to a deduction
    • I’d like to remind you of the ATO view about carrying forward tax losses, recently affirmed in the Trustee for the Payne Superannuation Fund [2015] AATA 58. We interpret the relevant tax laws to mean that where tax losses and outgoings in relation to exempt income exceed this exempt income, the excess can’t be carried forward to be applied to reduce ECPI in future years.

    Minimum pension payment requirement

    In September 2012, the Commissioner agreed to exercise his powers to allow a super income stream to be taken to continue and a fund to continue to claim ECPI where minimum pension payments are not made in certain circumstances.

    An SMSF may self-assess where:

    • the underpayment is small (less than 1/12 of the annual payment amount);
    • they have not previously self-assessed the exercise of the general powers; and
    • they have made a catch-up payment as soon as practical after identifying the shortfall.

    In all other circumstances the fund must apply for the ATO to exercise the general powers and must demonstrate the circumstances for the underpayment were outside the control of the trustee.

    We’ve finalised 242 cases where SMSFs have requested the exercise of this exception and have allowed only 20 per cent. In the remaining 80 per cent of cases, the funds did not demonstrate that the factors preventing payment were beyond trustee control. For example:

    • if the circumstance was a medical condition, it was not serious and was short term, with no supporting medical documentation
    • the circumstance that prevented payment being made was experienced by one/some but not all trustees. All trustees are equally responsible for running the fund and the Commissioner expects that if at least one trustee is not affected by the circumstance in consideration this trustee can carry out the necessary administration
    • the error was not made by a third party (eg a bank) but by a trustee
    • incorrect asset valuations
    • incorrect professional advice.

    Be careful in this area. It’s surprising how many SMSFs and their advisors carefully plan the sale of assets creating capital gains in the first year the member is in retirement but then forget to pay the minimum pension amount meaning they place at risk the ability to claim ECPI.

    Paying pension on death

    Earlier this year we published two ATO IDs – ATO ID 2015/2 and ATO ID 2015/3 – which deal with lump sum death benefits where the beneficiary intends to re-contribute the death benefit back into the fund. Broadly, to be a lump-sum super death benefit the benefit must be paid to the beneficiary. Journal entries are insufficient to establish that a super fund has paid a super death benefit. The death benefit must be paid to the beneficiary by transferring ownership of the deceased member's assets to the beneficiary. These ATO IDs don’t represent a new view but are simply a rewrite of old ATO IDs. They shouldn’t be interpreted as applying to situations which don’t result in a lump-sum death benefit. We are in the process of reviewing both ATO IDs.

    Planning for the unexpected

    With over half of all SMSF members aged 55 or older, there is an increasing risk that many, especially those in failing health, may find it difficult to manage their fund effectively as they age.

    Personal and economic goals and priorities change as people reach different stages of their lives. Younger SMSF members are encouraged to look to the long-term when planning their super and therefore often take on riskier investments. As they near the end of their working lives however, a more conservative approach is often recommended to provide more security in retirement.

    Many people start an SMSF because they want to actively manage their super investments but as they near retirement, they seek extra assistance from financial planners or administrators so they can focus less on managing their fund and more time enjoying retirement. While many trustees of course remain perfectly capable of effectively managing their financial affairs well past retirement age, there is a risk that some with diminished capacity to effectively manage their fund, may nevertheless continue to do so. Most don’t have a plan for what to do if they get to this point. Many SMSFs typically have two members with one member taking a more active role. If that member dies or becomes incapacitated the remaining member with little super knowledge or experience will have to assume responsibility for managing and restructuring the fund.

    A poorly managed fund can result in lost income and an erosion of lifestyle. This can be caused not only by bad investment choices but also through non-compliance with super and tax laws. For example, if minimum pension payments are not made each year, the fund will lose its tax exemption. In worst-case-scenarios, non-compliance can result in the fund losing almost half its assets in tax and the trustees being fined.

    We’ve already seen too many examples of an SMSF member dying without successor arrangements, leading to significant court costs to resolve. This has also happened with a trustee or trustees having no mental or legal capacity to make decisions and there being no way short of costly court action by family members to resolve the issue. There is also a significant emotional toll on family members and friends. These issues are a time bomb waiting to go off if not addressed now.

    We, as in the ATO as regulator and you as the profession, need to educate trustees about the necessity of forward planning and the consequences of leaving this decision until too late. A forward plan could include appointing a fund administrator to help run a fund, appointing an enduring power of attorney or even winding up and transferring to a managed fund once members reach a certain age or their health starts to decline. Trustees should be encouraged to make these plans well before retirement. This may involve discussions with family members as well as with trusted tax, super and legal professionals.

    Our videos Planning for the unexpected and When should I wind up my SMSF? provide a great starting point for these topics. We’re also aiming to get this message out to more trustees through SMSF News, other media and by providing information at retirement seminars.

    As life expectancy increases, super benefits will need to last longer, so it’s in a trustee’s interest to do everything in their power to ensure their fund is managed effectively to help protect their retirement benefits for the long term.

    Non-commercial limited recourse borrowing arrangements (LRBAs)

    Following consultation with industry, we released ATO ID 2014/39 and ATO ID 2014/40 which set out our view that the NALI provision applies to the non-commercial LRBAs involving related parties in those cases.

    These ATOIDs should not be seen as concluding that all related-party LRBAs give rise to NALI. It’s also not our intention to set benchmarks such as what we consider to be an acceptable interest rate. What we are likely to do is to apply scrutiny to related-party LRBAs where the terms of the loan, taken together, and the ongoing operation of the loan, aren’t consistent with a genuine arm’s-length arrangement (as in the type of arrangement you’d expect to get dealing with a third-party such as a bank).

    Requirements for setting up an LRBA

    An SMSF is not prohibited from borrowing money, or maintaining a borrowing of money, provided the arrangement entered into satisfies the following conditions:

    • the borrowed monies are used to acquire a single asset, or a collection of identical assets with the same market value (that are together treated as a single asset), which the fund is not otherwise prohibited from acquiring (called the 'acquirable asset'). The new law makes it explicit that borrowed money applied to expenses incurred in connection with the borrowing or acquisition (such as loan establishment costs or stamp duty), or expenses incurred in maintaining or repairing the acquirable asset, is allowed
    • the borrowed monies are not applied to improving an acquirable asset
    • the acquirable asset is held on trust (the holding trust) so that the SMSF trustee receives a beneficial interest in the asset
    • the SMSF trustee has the right to acquire legal ownership of the acquirable asset by making one or more payments after acquiring the beneficial interest
    • the acquirable asset is not subject to a charge other than as provided in relation to the borrowing by the SMSF trustee
    • the acquirable asset can be replaced by another acquirable asset that the SMSF is not otherwise prohibited from acquiring, but only in very limited circumstances as listed in the super law.

    For more information refer to the Q&A section on our website; it’s updated frequently.

    Finally, before we move away from LRBAs, I should just mention that, with exceptions, there is some uncertainty around the long-standing practice of ignoring the existence of an instalment trust for income tax purposes. Legislative amendments are proposed to amend the income tax law to provide look-through treatment for instalment warrants and instalment receipts, which will extend to LRBAs. You can read the exposure draftExternal Link at our website.

    SMSF loan arrangements that contravene super laws

    SMSF loan arrangements that contravene super laws are also on our radar at the moment. We’re concerned that some organisations are promoting arrangements where SMSF assets provide members with a current-day benefit using vehicles such as pooled investment trusts. Put simply, an organisation invites SMSF members to invest their fund’s assets in a pooled investment trust type of product where the scheme operator draws a commission and if this condition is met, monies from the trust can be accessed as a loan by the fund’s members.

    This is a simple form of such an arrangement but there are variations such as offering fund members’ relatives an opportunity to apply for a partial mortgage to cover the value of an asset and then invite their family to use their SMSF benefits to invest in a pooled investment trust. Their relatives can then be granted a second mortgage to further finance their investment.

    We encourage anyone who has been approached to invest their SMSF monies into a trust, company or investment product and then offered some or all of that money back as a loan, to seek independent, professional advice before proceeding.

    Keep an eye on our website as we’ll be publishing more information about these arrangements in a future edition of SMSF News.

    Conclusion

    Rapid demographic change and increased longevity mean that building and safeguarding Australians’ retirement incomes is more important than ever. Our superannuation system will remain the subject of debate and as the SMSF sector continues to grow, it’s also coming under closer scrutiny. As I’ve said before, it’s not just trustees’ behaviour and knowledge that drives the behaviour of SMSFs. It’s also the behaviour and knowledge of intermediaries – tax agents, accountants, advisers and auditors. In order to react to and forecast change and respond appropriately to risk we’ve been working very closely with all of you so that we can best understand and adapt to the environment in which we all operate.

    As an administrator and a regulator, the ATO is in the midst of an important period of reinvention and a big part of this has been listening to trustees and professionals. You told us you wanted greater certainty about your SMSF affairs. Our reworked compliance approach, the new penalty regime and auditor registration have all helped to deliver this. At the moment, members shifting to pension phase is a key wave affecting the sector. How and where SMSFs are investing their funds is a major focus for us. As we try to keep pace with – and sometimes ahead of – the game we work closely with the industry and our fellow regulators to take action on intermediaries who promote non-compliance or push the boundaries too far. As always, we thank you for your assistance.

    Last modified: 17 Mar 2015QC 44546