Cost-of-living pressures

The impact of higher inflation and interest rates not only applies to individuals, but also to SMSFs. BT head of financial literacy and advocacy Bryan Ashenden recognises some of the issues facing trustees stemming from the current economic environment.

Much has been discussed in the mainstream press about the cost-of-living pressures many Australians are facing currently. Over the past 12 to 18 months, at least, prices have been rising. According to the latest data from the Australian Bureau of Statistics, inflation is at 5.6 per cent, which is well above the Reserve Bank of Australia’s (RBA) target of 2 per cent to 3 per cent. Meanwhile, wages not have not grown at the same rate.

Interest rates have also been increasing, with the RBA announcing 12 rate rises across its past 14 meetings.

However, it is not only individuals who might be feeling the pain; some SMSFs could be too.

Like individuals, SMSFs face expenses on a daily basis, and those expenses have been increasing due to inflation. SMSFs need to be conscious of this, and in line with requirements under the sole purpose test and their investment strategy considerations, trustees need to ensure they have sufficient liquidity to meet the needs of the fund. For many SMSFs, this may be a simpler requirement related to administration-related costs. But where there are different investments, such as property or exotic investments, like artwork or antiques where there is insurance in place, it is important to be aware of any potential increases occurring on those insurance policies as they could be substantial in the current environment.

There is an even greater need for consideration of these aspects when members of the SMSF undertake any relevant services themselves for the fund. In recent times we have seen a greater focus from the ATO on any related-party dealings in the SMSF environment. Where services are provided and not charged or paid for on an arm’s-length basis, there is the potential for the non-arm’s-length income (NALI) provisions to be triggered. Similarly, there are non-arm’s-length expenditure (NALE) provisions that apply to ensure expenses are charged and paid for on an arm’s-length or third-party market basis. Failure to meet these requirements runs the risk the income of the SMSF could be subject to tax at penalty rates equal to the highest marginal tax rate.

For accountants, as an example, when undertaking the administration and taxation work for their own SMSF, they need to consider how much they are charging other clients for the same work. The amount charged to their own fund should be based on a similar methodology. Recent draft legislation is proposing the difference between the expense charged and what would be the market rate for that expense will be subject to penalty tax under the NALE provisions. The draft legislation on this, contained in the Treasury Laws Amendment (Measures for Consultation) Bill 2023: Non-arm’s Length Expense Rules for Superannuation Funds, released for consultation in mid-June, contains the following on this point in example 1.1 of the accompanying draft Explanatory Memorandum:

“Al is the sole trustee of their SMSF of which they are the sole member. Al is an accountant and provides general accounting services worth $3000 to their SMSF, which the SMSF acquires free of charge.

The acquisition of accounting services by the SMSF constitutes a scheme between Al and his SMSF in which the parties were not dealing with each other at arm’s length, and no expense was incurred when the SMSF would have been expected to have incurred an expense in respect of its acquisition had the parties been at arm’s length, so the non-arm’s-length expenditure provisions apply.”

While this example focuses on a situation where the services were provided for free, there are other examples where the services were not free, but provided at a cost less than a market rate. So while the expense rate could have been appropriate in the past, not adjusting it for prevailing market conditions, where the rate may have been impacted by inflationary pressures, could result in potential breaches into the future.

Perhaps, importantly, another example in the draft Explanatory Memorandum, example 1.3, provides a reminder for financial advisers about charging fees for the investment advice provided to their own SMSF, with the commentary noting such services provided at a rate less than market value, including being provided at no cost, could invoke the NALE provisions.

In response to inflationary pressures, we have seen the RBA act to raise interest rates in a move designed to bring inflation under control and ideally back to within a targeted range. These increases in interest rates over the past 12 months have seen many Australians impacted as the variable rates on their loans have risen. Again, SMSFs are not immune from similar pressures.

Where an SMSF has a related-party borrowing in place, a key consideration has always been the interest rate charged on that loan. In order to be viewed as a loan made on an arm’s-length basis, within the ATO’s safe harbour approach as set out in in Practical Compliance Guideline (PCG) 2016/5, the interest rate needs to be calculated by reference to the RBA’s indicator lending rate for banks providing standard variable housing loans for investors. If the loan is in respect of real property, the relevant rate is that indicator rate. If the loan is in respect of a parcel of listed shares, it is the indicator rate plus 2 per cent.

For the year commencing 1 July 2023, the relevant indicator rate is 8.85 per cent – a jump of 3.5 percentage points from the indicator rate that applied for 2022/23 of 5.35 per cent. For loans used to acquire a parcel of listed shares, the new rate will be 10.85 per cent.

While fixed rate loans are an option to be considered, it is important to note the rate to be used for a fixed rate loan, which under the safe harbour approach can be for a maximum of five years for a propertyrelated loan or three years for a loan for listed shares, is the same rate. There is no adjustment up or down for expected interest rate movements into the future. This means an SMSF trustee who had been savvy enough to fix a portion of their loan before the end of the financial year could have a fixed rate loan of 5.35 per cent. Unfortunately doing it now will mean a fixed rate of 8.85 per cent will apply.

SMSFs with these related-party loans may, as a result, feel a greater impact from the inflationary pressures and their impacts on interest rates from 1 July 2023 due to the substantial rise and will need to ensure they have liquidity plans in place to meet these increased costs. SMSFs with thirdparty loans from a financial institution do not need to rely on PCG 2016/5 as the loan is likely to be on an arm’s-length basis already. Again, they are not immune from the increase in interest rates, but the change may have been felt gradually over the past 12 months with smaller but more regular increases to interest rates over that period.

A final area of which SMSF trustees will need to be cognisant in the current environment is the pension needs of members. While awareness should not be an issue, given the trustees are also the members, it is the impact of cost-of-living pressures and inflation that may require changes to strategies for a number of reasons, including the following:

1. For the 2024 financial year, the previous 50 per cent reduction in the minimum income stream payment amounts for market-linked income streams no longer applies. For members who had been drawing at the reduced minimum levels, higher payments will now be required to be taken. Hence SMSF trustees will need to ensure there is adequate liquidity to enable this. Where a reduced payment continues to be taken throughout the year, with a planned catch-up payment to be made at the end of the year, it will be important to ensure a larger payment is made before 1 July 2024, and that the total payments across the year are at least equal to the standard minimums now applying. Failure to do so can mean the income stream does not exist, and the tax-free status on underlying earnings in the fund could be lost.

2. Irrespective of the legislated minimum payments from income streams, members may need to access additional funds to meet their cost-of-living requirements. SMSF trustees should be prepared to ensure there is sufficient liquidity for those requirements.

Finally, it is worth noting some SMSFs may still be running lifetime complying income streams set up many years ago, with the income streams structured to have annual payment amounts indexed to movements in the consumer price index. With the rate of inflation having risen significantly in recent times, the payment requirements from these income streams may have increased significantly. While this gives rise to liquidity considerations, similar to those discussed earlier, it also raises questions over the investment strategy for the underlying assets supporting these pensions to ensure they can continue to meet the income needs of the member for the expected remaining life of those income streams.