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  • ATO compliance and regulation – 11 September 2014

    Keynote address by Stuart Forsyth, Assistant Deputy Commissioner Superannuation

    ICAA National SMSF Conference

    Strategies Today for a Stronger Tomorrow

    Thursday 11 September, Hilton, Sydney

    Over one million Australians, through their membership of some 530,000 self-managed superannuation funds (SMSFs), are taking direct responsibility for their financial future. This number continues to grow and, although we still have a way to go in terms of encouraging youth to engage with their super, we’re seeing a lot of younger people (in the 35 to 49 age bracket) choosing to run their own super funds. Professional, well-managed and performing on par with APRA funds, most SMSFs comply with the rules and deliver for their members.

    It’s true that SMSFs are not for everyone; they require significant work, time, diligence and knowledge to operate. But as the regulator, we can report that most are doing the right thing. We receive about 11,000 auditor contravention reports (ACRs) a year, which represents only about 2% of all funds; this proportion has remained steady while the number of funds has increased. And about half the contraventions reported to us are already rectified.

    So while we’re turning our thoughts to developing strategies for ‘a stronger tomorrow’ I think we should also take a moment to reflect on yesterday, so to speak. Certainly the ATO has worked hard to educate and assist the sector and my staff remain passionate about helping trustees and the professionals who support them. But we don’t work in isolation, and it’s to the credit of trustees, the professionals here today, and in the sector more broadly, that SMSFs have defied the sceptics.

    To put things in perspective, a lot of the strategies that seem at times to occupy us in debate are really at the margins of why people choose to manage their own retirement rather than join in the ‘main game’. In fact the main game, appropriately for most SMSF trustees, is investing for retirement. It’s that simple. This is why today I want to cover the tax and regulatory issues that are adopted, talked about, or, I suspect in some cases, used by particular advisers to distinguish themselves from their competitors.

    I’d also like to tell you about the innovative work the ATO is doing to help educate trustees and potential trustees, talk about why we’re confident that the sector is in good health and discuss our SMSF compliance program in some detail. Before I do this, I’ll quickly run through some figures. As you know, we regularly publish statistics and data about the SMSF sector through our quarterly reports. These reports form the basis of much of the analysis and commentary about the state of the sector. So, where is it at? As with the number of SMSF members and funds, SMSF assets continue to grow; an estimated $557 billion in total assets is mainly held in cash, term deposits and listed shares. There have been suggestions that SMSF numbers will taper off, but we haven’t really seen any sustained dip in registrations and in the past five years there’s been 27% growth. And while we’re starting to see an increase in wind ups as some members and their funds exit the system, 90% of funds established in the 10 years to 2012 still exist.

    Transforming the client experience

    As with all aspects of tax and super administration our compliance work starts with understanding the overall population and looking, in the first instance, to maximise voluntary compliance. In the SMSF sector our primary focus is to engage and assist trustees and the professionals who support them. To this end, we provide a range of resources including:

    • the eSAT tool for auditors which can be found at ato.gov.au/eSAT
    • online calculators such as the super co-contributions calculator
    • SMSF lifecycle publications and other resources, available on our website
    • SMSF News (released every two months) at ato.gov.au/smsfnews
    • By now, you’ve probably seen or experienced some of our newer, more contemporary, communications:
    • a suite of short (and entertaining) education videos on YouTube covering all aspects of running an SMSF available at ato.gov.au/smsfvideos
    • webinars – these have been a big success since they were launched in June. Close to 6,000 people have attended so far and almost 100% said they’d like us to use this channel for future updates. We’ve listened and will run webinars regularly; stay tuned
    • SMSF content on the ATO app; we’ll continue to add to this over time.

    SMSF assistExternal Link, now available on our website and the ATO app, provides ready access to a wide range of topics associated with all stages of SMSFs. Just type in a question or select a topic to get specific information in an easy to understand format.

    Compliance

    In the past year we’ve undertaken a little over 36,000 compliance activities. Many of these were in the form of targeted mail-outs; however we also rang over 6,000 trustees and SMSF professionals to discuss our concerns in addition to formally reviewing and/or auditing over 5,000 funds.

    In the main our compliance activities led to education outcomes and enforceable undertakings, but we also made 118 funds non-complying and disqualified 545 trustees. There has been a decline in large scale illegal early release (IER) of super since we introduced an automated risk assessment of trustees and a member verification process. This year, we prevented 236 funds from entering the system and removed 160 funds where we suspected illegal access was planned. This activity has proven very effective at reducing the incidence of IER and we remain vigilant for new schemes and methods.

    SMSF auditor compliance is another key facet of our work. We work closely with ASIC to provide support to and monitor the compliance of SMSF auditors. Last year we audited about 150 SMSF auditors and to date we’ve provided details on 339 auditors to ASIC as part of our discussions as well as formally referring 13 auditors to them for action.

    Limited recourse borrowing arrangements (LRBAs)

    The data in our Quarterly statistical reports is based on information collected from the labels in the SMSF annual return (SAR). Before the 2012 SAR, there was no label for ‘LRBA assets’ and therefore no information in the quarterly reports about these. Instead there was a label, and data in the reports, for ‘derivatives and instalment warrants’ (instalment warrants became LRBAs when section 67A was added to the SISA. As this label covered derivatives as well as instalment warrants/LRBAs, the data in the reports didn’t report LRBAs separately). The 2012 SAR was the first to have a separate label for LRBA assets. The original June 2013 estimate for LRBAs was based on data from the 2012 SAR, but as we now have the majority of the data from the 2013 SAR we’ve used it in this quarterly report to revise our original estimate of LRBA assets as at June 2013.

    So, why the jump from the $2.6 billion estimate (extrapolated from 2012 SAR data) to $8.3 billion (based on 2013 SAR data) when there was an LRBA assets label in the 2012 SAR? We think this is because in the 2012 SAR people were still not sure which label to report at – either the label for the type of asset acquired or the LRBA asset label. We made this clearer in the instructions for the 2013 SAR. Hence, we think, a drop in the amounts reported at property labels and an increase in the amount at the LRBA asset label.

    While it’s likely that there has been continued growth in the use of LRBAs, this change is mainly due to the ATO’s improved approach to collecting LRBA data from SARs. The improved data collection and label changes on the return mean that some amounts previously reported as property assets are now being reported as LRBA assets (a decrease of $6 billion for real property assets compared to the $5.6 billion increase in LRBA assets). Our data largely cannot distinguish which part of the increase is due to growth in the use of LRBAs and which is due to improved data.

    More effective use of auditor contravention reports (ACRs)

    In the past two years we’ve made a major change to our SMSF compliance program. We had previously developed a complex multi-faceted program with a mix of case types and while this ensured we addressed risks it did not, for example, give a good user experience to trustees with an ACR.

    With auditor registration now in place, we decided that the high-value intelligence we were obtaining from auditors needed to be treated with more priority. We therefore simplified our program and put ACRs at the centre. Previously, ACRs triggered a letter to trustees and that letter was the same whether we already knew that we would take no further action or we would or may audit the fund. Over time, some were treated by an audit or review but essentially trustees who only received the letter were unsure if a case would be started. In fact, cases could take 18 months before they began. In our new program, we contact the majority of trustees within eight weeks, either by letter or by telephone, giving them certainty.

    All ACRs trigger an assessment of the fund as either low-, medium- or high-risk. SMSFs rated as low-risk receive a letter advising that the matter is closed. Trustees of SMSFs rated medium-risk receive an education-focused telephone call which is designed to provide assistance and prevent the need for an audit; most matters are resolved in 10-20 minutes. About 9% of these telephone contacts result in an escalation to the high-risk category. For SMSFs rated high-risk, or escalated to high-risk, our work starts by contacting the authorised representative, normally the tax agent. While we will usually assess funds as low- and medium-risk within eight weeks of the ACR being lodged, we’re not yet achieving this time frame with all higher-risk cases. However, if they do fall outside the eight-week timeframe, it’s not by much. Certainly no one now needs to spend 18 months wondering what the ATO will do.

    We note that within the 9% of cases that are escalated there are some trustees who will not talk to us when we call. We’re also finding that it can be difficult to obtain contact numbers so we’re investigating the possibility of capturing this information in advance, perhaps on the ACR. We see this shift as a major change because of the direct and timely contact. Early feedback has enabled us to refine our processes to reduce escalations and ensure that the conversation is the focus rather than asking for data or undertakings. This is in essence a more economical outcome for us and much more timely.

    Feedback from some trustees is that they are very relieved to have the matter dealt with. Others are attributing their involvement in an SMSF to an adviser and deciding to close their fund after rolling over the remaining balance. We realise that the real story may be more complex.

    We also hope that the shorter timeframe will make our actions more transparent to advisers and auditors. Consistent feedback from approved auditors is that they’d like to know when we take action on the ACRs they lodge with us. As most matters will be resolved within eight weeks this should be less of an issue in future. Privacy restrictions make it impossible for us to automatically advise the auditor.

    Our program for this year consists of:

    • ACR-triggered actions  
      • 4,500 finalised letters for low-risk rated SMSFs
      • 1,800 outbound calls for medium-risk rated SMSFs
      • 1,800 comprehensive audits for high-risk rated SMSFs
       
    • 450 audits created against emerging risks and intelligence received (non-ACR related work).

    In the past ten years, I’ve seen variations of some of the strategies that are around today. Some of these, such as re-contribution, which essentially involves moving money out of the fund and then using that money to fund a contribution, are well established. Re-contribution for example, may provide better tax outcomes such as deductions for contributions or a change in the tax-free proportion. As with all strategies, facts are what drive outcomes. The availability of transition-to-retirement pensions is often associated with variations of this strategy which may also include a salary sacrifice component. However, lower contribution caps have reduced the value of re-contribution.

    Borrowing, particularly from related parties

    There are some in the SMSF industry who advocate entering into a limited recourse borrowing arrangement (LRBA) with a related party under non-commercial terms. We assume that the purpose is to shift wealth into an SMSF and to minimise, and in some instances possibly avoid, tax. To provide some context: for the June quarter 2014, the SMSF statistical report estimates that $8.7 billion was held as limited recourse borrowing arrangements.

    We continue to receive private binding ruling requests in relation to this strategy. In April, we released an edited version of a private binding ruling request. Based on the facts provided, we stated that income derived by the fund from this nil-interest rate loan arrangement gave rise to non-arm’s length income pursuant to section 295–550 of the Income Tax Assessment Act 1997. The application of this decision is that the non-arm’s length income derived from this arrangement would be taxed at 45% (47% while the temporary budget repair measure is in place).

    In the case in question, a super fund proposed to borrow from a related party. The directors of the corporate trustee were the only members of the fund and the fund was in pension mode. The loan agreement proposed to apply a nil-interest rate. The loan was to be repaid in a single lump sum at the end of the term of the loan. No end term or date was mentioned in the loan agreement. The related party proposed to lend 100% of the value of the assets to be acquired. The asset to be acquired (in this case listed shares) would be held via a custodial trust.

    The elements that led us to conclude that the parties would not be dealing at arm’s length (amounting to a ‘scheme’) in this arrangement were:

    • the lender is not compensated for the opportunity cost in lending
    • there are no regular periodic repayments – only a single lump sum repayment at the end of the loan term
    • 100% of the value of the assets to be acquired will be lent
    • no insistence by the lender on personal guarantees from members of the fund
    • absence of mechanisms for the lender to protect the underlying value of the asset.

    We also concluded that the income that would be derived by the fund would be greater than the amount the fund might have been expected to derive if the parties were dealing with each other at arm’s length.

    In sum, while this private ruling should not be seen as prohibiting LRBAs between related parties, what is clear is that the Commissioner will take the view that dealings between a fund and a related party must be seen to be at arm’s length. A non-interest loan on its own won’t be enough to taint the income of the fund as being non-arm’s length, if it’s derived from a related party investment through an LRBA, but it is a considerable factor. Coupled with other factors such as a high loan value ratio, we’re likely to apply considerable scrutiny to the arrangement.

    Dividend washing

    Dividend washing is a share trading strategy that enables a taxpayer to access double the franking credits attached to fully franked dividends even though the taxpayer effectively holds only one parcel of shares. The shares are purchased in a special market that allows the taxpayer, often an SMSF, to reacquire shares with a dividend attached, after the ex-dividend date, allowing them to take advantage of the additional franking credits to offset their tax liability or receive a refund of the excess imputation credits.

    The government announced in the 2013–14 Budget that the loophole would be closed, retrospectively, from 1 July 2013. The ATO position was issued in April 2014 in Taxation Determination TD 2014/10 Income tax: can section 177EA of the Income Tax Assessment Act 1936 apply to a ‘dividend washing’ scheme of the type described in this Taxation Determination?

    Home loan unit trusts

    We have identified a potential home loan unit trust arrangement which involves a residential property being purchased by a non-geared trust whereby units are purchased by the SMSF, related family trust and SMSF members. The purchase of the asset is effectively financed through funding from the SMSF. The residential property is occupied and rented by the member. The rental income less expenses is paid out to unit holders but the proportion of the distributions is not consistent year by year. This type of arrangement potentially contravenes the sole purpose test and/or the provision of financial assistance to a member. If there is a form of ‘gearing’ or investments in other entities involved within the trust, then the SMSF may also find itself in breach of the in-house asset provisions.

    Dividend stripping

    Another retirement planning arrangement we’re seeing involves a private company with retained earnings which are distributed by way of a franked distribution to an SMSF in circumstances where the SMSF is entitled to a refund in relation to the franking credits attached to the distribution. This ultimately means that the earnings of the company are tax free in circumstances where the SMSF holds the shares for a short period of time at no risk to realise the cash and franking credits in the most tax effective manner within an income year. As our preliminary data analysis indicates the arrangement may have proliferated, we’re developing a Taxpayer Alert in conjunction with an ATO view.

    Conclusion

    Most funds comply with the rules and deliver for their members. And while the media may at times sensationalise stories about SMSFs and their trustees, the truth remains that the vast majority work within the law just like any other fund. That said; there is always room for improvement and we do focus strongly on education, voluntary and by direction, to assist compliance. Our aim is to keep working with auditors, trustees and superannuation professionals to ensure easy and timely access to the information they need, in a suitable format. On the subject of education, I’d like to congratulate the ICAA for establishing a free SMSF trustee online course with the CPA at smsftrustee.comExternal Link. The course is approved by the ATO for use by trustees when we direct them to undertake education but perhaps even more importantly, it’s simply a great resource for all trustees.

    Last year at this conference I focused on change: in the super landscape, in the maturing SMSF sector, and in the ATO itself. Today, I hope I’ve shown some of the positive outcomes we’ve achieved together. We’ve listened closely to our stakeholders, we have a regime in place that enables us to address wrongdoing appropriately, we have a well-established and ever improving compliance program, and auditor registration with ASIC has been operating successfully for a year now.

    While it’s always wise to prepare for tomorrow, it can be equally educative to look back.

    Thank you.

    Last modified: 12 Nov 2014QC 43090