The most taxing SMSF issues

Superannuation is the most tax-effective saving environment available to Australians. Liz Westover partner and national SMSF leader at Deloitte Private examines the various requirements that shape this favourable tax framework.

Quite simply, one of the biggest incentives for people to contribute to super, to lock their money away until retirement and to commence income streams is tax. Superannuation remains the most tax-effective means of saving and the tax incentives offered to Australians are a major driver of the growth of Australia’s superannuation system – currently sitting at around $3.4 trillion, according to Australian Prudential Regulation Authority figures released in March.

It is critical therefore for any tax advisers in the SMSF industry to have a solid understanding of tax rules in super to not only maximise retirement savings, but also to navigate our complex tax and

super system for compliance purposes. Following are some of the key issues in tax in super and a number of the sometimes overlooked tax matters.

Claiming a personal contribution deduction

A frequently misunderstood process is claiming a deduction for personal super contributions, particularly around the paperwork needed and timing within which it must be completed.

In order to claim a tax deduction for personal superannuation contributions, individuals must complete a “Notice of intent to claim

or vary a deduction for personal super contributions”, a section 290-170 notice of the Income Tax Assessment Act (ITAA), provide that form to their super fund (including SMSFs) and have the super fund supply an acknowledgement letter to them.

Further, this paperwork must be in place by the date of lodgement of their personal tax return and no later than 30 June of the year following the year of contribution. Failure to do so will result in a loss of entitlement to claim the tax deduction. Importantly, the commissioner of taxation has no discretion in relation to these requirements.

NALE and NALI

Non-arm’s-length expenditure (NALE) remains a challenging area for many SMSF trustees and their advisers. An SMSF that does not incur or pay expenses on an arm’slength basis risks the income of the fund being treated as non-arm’s-length income (NALI) and taxed at the highest marginal tax rate. This can include annual income, as well as capital gains.

Rules around NALE have been in force since 2018, particularly in relation to those expenses with a nexus to particular income of the fund, for example, property management fees in relation to rental property income. Since that time, the ATO has formed a view stipulated in Law Companion Ruling 2021/12 that general expenses have a sufficient nexus to all income of the fund. While it has been prepared to give trustees time to adjust to this view, as stated in Practical Compliance Guideline 2020/5, from 1 July 2022 it is expected to make further inquiry and take action in relation to these general expenses not paid on an arm’s-length basis.

As such, where family offices or accounts departments assist in the administration of SMSFs, a fee may need to be paid by the fund. Further, any advisers using their own firms to assist with administration or tax agent services will need to consider how these rules may apply to them.

Taxable and tax-free components

For many superannuants, the make-up of their benefits as either taxable or taxfree will never be an issue, certainly while they are alive, as benefits are generally tax exempt for those over the age of 60. Where superannuation benefits are ultimately paid to a beneficiary following the death of the member, however, tax will be payable on the taxable component where the beneficiary is not a tax dependant. This mainly impacts adult children. Importantly, if no tax-free component can be identified or has been tracked, the whole amount will be treated as taxable and taxed at 15 per cent plus the Medicare levy.

Most SMSF software easily tracks these components, but where specialised software is not used, other records will need to be kept and calculations made annually to ensure they are appropriately tracked.

Gains and losses

A provision of tax law that can also be overlooked relates to the requirement for capital gains tax (CGT) to be the primary code for calculating gains and losses within a super fund. While it is broadly understood super funds can’t ‘trade’, and therefore all buying and selling of securities will be subject to the CGT provisions, there are certain assets that are excluded from this treatment.

As the breadth and scope of modern assets expands, some assets growing in popularity may actually be able to be treated as income and not capital gain. The types of assets in this group are generally those with predominantly debt-like features. This can be a complicated area and may require specialist advice.

Foreign exchange

In a global economy and as the use of investment managers increases, the incidence of SMSFs holding foreign bank accounts is on the rise. For example, it would not be unusual for managed portfolios to have holdings in foreign markets.

Generally, foreign exchange gains and losses will give rise to assessable income or an allowable deduction, but provisions also apply that would allow these gains and/ or losses to be ignored. Specific criteria must be met to enable an election to be made. This would generally apply where the value of the foreign bank account does not exceed $250,000, although some minor fluctuations are allowed. The ability to use these provisions is not automatic and an election must first be made. Again, this can be a complicated area requiring specialist advice so care must be exercised where a fund holds foreign bank accounts.

Tax-effect accounting

Most tax agents do not use tax-effect accounting in the preparation of financial statements and tax returns. However, there are times when it is appropriate to do so. Typically, when a member is rolling out of a fund or when splitting assets during marital breakdown, tax-effect accounting will ensure the departing member effectively pays their share of tax on assets rather than having the remaining member being left with the tax bill upon the ultimate sale of the assets.

While there is an argument tax-effect accounting can give a truer account of members’ entitlements by allowing for notional tax should the assets be sold on a particular date, in super it can be a mistake to assume any tax paid as income attributable to members in retirement phase will be tax-free.

It is worth noting where tax-effect accounting can be used at a particular time for a specific purpose, as described above, the fund can stop using this method later.

Franking credits and the 45-day rule While not exclusive to SMSFs, it is a timely reminder an entity must hold shares at risk for at least 45 days to be entitled to claim franking credits attached to dividends received. It is important to note the day of acquisition and disposal is not included in the 45-day calculation.

Small shareholders may be entitled to an exemption from this rule if their total franking credit entitlement is less than $5000.

Claiming exempt current pension income

Around 45 per cent of all SMSFs are either wholly or partially in retirement phase. For these funds their biggest concession will likely be exempt current pension income (ECPI).

Calculating ECPI is undertaken using either the segregated method or the proportionate method. The segregated method allows income from assets segregated for pension-paying purposes to be ignored, including funds that are only paying income streams in retirement phase.

The proportionate method is used for funds that have accumulation accounts as well as pension accounts and can also be used where funds were not solely paying income streams for the whole year. When claiming ECPI using this methodology, an actuarial certificate must first be obtained to ascertain the percentage of income that will be exempt from tax.

Recent changes in law have allowed for more flexibility in choosing the ECPI methodology that can be used, but only in certain circumstances. Where a fund is 100 per cent in retirement phase for part of the year, they can either use the proportionate method for the whole year or only that period in which they held an accumulation account and segregated method for the period they were wholly in retirement phase. In addition, those funds wholly in retirement phase for the entire year, but could not previously use the segregated method because they held disregarded small fund assets, where a member in retirement had a total super balance in excess of $1.6 million, will no longer be required to obtain an actuarial certificate to claim ECPI.

Deductions in super

Not all expenses incurred by a super fund are going to be fully tax deductible. Some expenses may need to be capitalised, such as certain legal fees, and others, like fines, are not deductible at all.

Expenses incurred that are typically deductible, under general principles of section 8-1 of the ITAA, include accounting, actuarial, audit and other administration costs. Some expenses have specific provisions for deductibility, including the supervisory levy and tax-related expenses defined in section 25-5 of the ITAA. Some legal expenses may be deductible, such as those needed to update a deed in response to legislative changes. However, a deed update undertaken for other purposes may not be deductible – a good reason to ensure regular deed updates are undertaken.

Set-up costs for SMSFs are generally not deductible. Financial advice can be confusing as to deductibility. Generally, advice in relation to investment management is likely to be deductible, but structuring advice will not be.

ATO Tax Ruling (TR) 93/17 contains good commentary and plenty of examples on income tax deductions available to super funds and can be a useful resource to ensure deductions are being claimed correctly.

Deductions when claiming ECPI

When a fund claims a deduction for ECPI, it is not entitled to claim a full tax deduction for all expenses. Rather, only a portion of expenses will be deductible and when a fund is completely in retirement phase for the whole year, no deductions can be claimed.

When apportioning expenses for deductibility, different methods can be used, but whichever method is employed, it must be done so on a fair and reasonable basis. Many tax agents simply apply the actuarial percentage to expenses, but some expenses directly attributable to paying pensions may not be deductible at all. Conversely, some fund expenses can still

be deductible in full, for example, the ATO supervisory levy.

TR 93/17 also discusses methods of apportionment that can be used.

Statistics

According to the data contained in “ATO Self-managed super funds: A statistical overview 2019-20”, the SMSF sector is currently serviced by 13,800 tax agents who account for the servicing of 99 per cent of funds. While the average number of funds per agent is around 31, the median is nine, which means there are a significant number of agents who only have a small number of SMSF clients. In fact, over 9200 of these tax agents have 20 or fewer SMSF clients. Thirty-two tax agents have over 500 clients and 861 have between 101 and 500 clients.

Tax agents have an obligation to only undertake tax work for which they are qualified and experienced. The SMSF sector continues to grow and our superannuation laws continue to become more complex. As such, the need for SMSF specialists will only increase, along with the hope those not specialised in this area will seek out the assistance of those who are.