SMSF Alert: January 2015

Liam Shorte and Richard Livingston highlight the past two months’ key SMSF developments.

Key Points

  • Tax Office decisions on limited recourse borrowing arrangements
  • Financial System Inquiry targets direct borrowing by super funds
  • Tax Office determination on commuting transition to retirement pensions to lump sums
  • SMSF trustee penalised for making loans to relative

Welcome to the first SMSF Alert of 2015, covering the period since mid-November last year. If you’ve borrowed money through your SMSF, there were some developments in late 2014 of particular interest (or concern) to you.

Let’s take a look.

Tax Office decisions on limited recourse borrowing arrangements

In SMSF Alert: April 2014 we discussed a private tax ruling with negative implications for low-interest, related-party loans made to SMSFs.

The Tax Office has now released two public decisions (ATO ID 2014/39 and ATO ID 2014/40) that explain its treatment of non-commercial, limited recourse borrowing arrangements used to purchase both shares and property.

Interpretative decision ATO ID 2014/39 relates to a case where a related-party loan was used to fund 100% of the purchase price of a portfolio of shares. The loan was made for a term of 20 years, with zero interest and no personal guarantees.

In this case, the Tax Office has said that, because the loan was not made on normal commercial terms, it would treat the income on the share portfolio as ‘non-arms length income’ of the SMSF causing it to be taxed at the top marginal tax rate (currently 45% plus 2% medicare levy). This applies whether the SMSF is in accumulation or pension mode.

The other decision – ATO ID 2014/40 – applies to the purchase of property. Here, a related-party loan was used to fund 80% of the purchase price of a property. The loan term was 15 years (with periodic repayments of principal), no interest was payable and no personal guarantees were given.

The Tax Office again indicated that income from the property would be treated as ‘non-arms length income’ and taxed at the top marginal rate (plus medicare levy).

Given the difference between the top marginal tax rate and super fund (or private entity) tax rates, this is likely to be a disastrous outcome for many. So, if you’re using related-party loans you need to make sure they are on arm’s length terms and that that’s supported by evidence.

Following the release of the decisions, the Tax Office also updated its website to provide guidance on how the principles established would be applied to other cases. You can access the guidance here.

Action point: If your SMSF has used a related-party loan arrangement, ensure you have supporting documentation in place to show that it was made on arm’s length (commercial) terms or, if it wasn’t, you should seek personal advice on your options.

Financial System Inquiry

In SMSF Alert: October 2014 we said the Financial System Inquiry (FSI) had received submissions on changes to borrowing inside super, in particular targeting SMSFs using loans to buy residential property.

The FSI panel has now handed down its Final Report and recommended that the Government restore the prohibition on direct borrowing by super funds (including SMSFs). The FSI panel’s concerns are that direct borrowing, while currently small, could pose a threat to the stability of the superannuation system if allowed to continue to grow.

Importantly, the panel recommended that existing borrowing be allowed to continue. But borrowers should remember that many third-party loans contain ‘review events’ (that allow the lender to terminate the loan) and interest rates set by the lender. If the market for direct loans dries up, current lenders may look to exit the business and ‘review events’ are a handy way to force borrowers to repay their loans. Alternatively, lenders may simply impose much higher interest rates if they are no longer competing for new customers.

In addition to the direct borrowing suggestions, the FSI panel made a number of recommendations related to the superannuation system generally. These include setting clear objectives for the superannuation system, improving the efficiency of the default fund regime, and removing barriers to the development of retirement income products. The panel also made recommendations on improving the quality of financial advice. More information can be found here.

We expect there will be lots more reviews, consultation and submissions before any changes to reflect these latter recommendations are implemented.

Tax Office determination on commuting transition to retirement (TTR) pensions

In November, the Tax Office also published SMSFD 2014/1 setting out its views on commuting transition to retirement (TTR) pensions to a lump sum, namely:

  • where a TTR pension is partially commuted to a lump sum and paid out (not rolled over) that payment counts towards the minimum annual payment for that year;
  • where a TTR pension is partially commuted to a lump sum it does not count towards the 10% maximum annual payment for that year; and
  • where a TTR pension is fully commuted to a lump sum then the payment does not count towards either the minimum or maximum, since the pension is treated as having ceased immediately prior to the payment being made.

Note that the treatment may be different in prior years or where a treatment has previously been agreed between the SMSF and the Tax Office.

Federal Court decision: Deputy Commissioner of Taxation vs Lyons

A recent court case again highlights the importance of understanding the rules that apply to SMSFs, even where you are relying on external advice.

In this case, one of the SMSF trustees, Mr Lyons, made loans totaling $190,000 to his brother-in-law, which was the bulk of the assets of the fund. These funds were then transferred across to a struggling business operated by Mr Lyons.

Advice was obtained from a financial adviser that the loans could be made to the brother-in-law. The advice was incorrect.

Despite following the advice, Mr Lyons was ordered to pay fines and costs, totaling about $40,000, and the concessional tax treatment of the fund was cancelled. It was indicated that the penalty would have been much higher if not for the remorse and conciliatory nature of Mr Lyons.

Action point: This case serves as another reminder to be familiar with the things your fund cannot do – for instance, making loans to relatives – even when you rely on an adviser. Whilst the ‘in-house assets’ rule allows some related-party transactions up to 5% of the fund’s value, best practice is to keep the fund completely clear of related-party assets, since a change in value of the asset or the fund can mean the asset has to be removed.

Other recent developments

You may also be interested in the following:

  1. Tax office webinars for SMSF trustees – In a previous SMSF Alert we mentioned that the Tax Office has started running webinars for SMSF trustees and superannuation professionals. Recordings of completed webinars can now be accessed online.
     
  2. Electronic record-keeping for SMSFs – To allow SMSFs to benefit from the cost advantages of digital storage, the Tax Office has updated the SMSF record-keeping requirements to allow records to be kept electronically.
     
  3. Tax Office consulting on contribution reserving strategies – In SMSF Alert: March 2014 we highlighted the complications posed by the Tax Office systems for those using the ‘contribution reserving strategy’. We understand that the Tax Office is consulting with stakeholders with a view to making the process more efficient.
     
  4. Latest ASFA retirement standard released – ASFA has released its Retirement Standard for the September 2014 quarter. It shows that, in general, a couple looking to achieve a comfortable retirement needs to spend $58,326 a year, while those seeking a ‘modest’ retirement lifestyle need to spend $33,784 a year.
     
  5. Permanent ban of Trio chief investment strategist upheld – The Administrative Appeals Tribunal has affirmed the decision by ASIC to permanently ban Eugene Liu from providing financial services.

Liam and Richard are founders of Eviser.

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