CPD: SMSFs and tax

According to the latest ATO statistical report (December 2023), SMSF members are heavily invested in equities; listed shares comprise 29 percent of total SMSF assets. Cash and term deposits are the next largest investment, comprising 15 percent, followed by non-residential property at around nine percent.

Like all superannuation funds, SMSF trustees must meet the sole purpose test: to run their fund for the sole purpose of providing retirement benefits as outlined in the Superannuation Industry (Supervision) Act 1993 (SIS Act).

The rationale for SMSFs

There are several reasons given for eschewing a corporate, retail or industry superannuation fund in favour of an SMSF. The most common reasons are:

• direct ownership of assets (rather than beneficial ownership through a superannuation fund)
• able to own direct property (residential or commercial)
• able to borrow money via a closed trust (to be used for investment purposes)
• able to own a broader range of direct assets, including artworks and collectibles
• capacity to manage tax more effectively.

The ability to maximise the benefits of SMSFs will vary for each fund and be dependent on its investment objective and those of its members. However, the reasons outlined above are not relevant for all funds or members and, in some cases, benefits may be outweighed by the costs and time requirement associated with managing an SMSF.

Those requirements include:

• the trustees need the time and skills to manage an SMSF
• trustees are responsible for operating the fund within the law; failure to do so may lead to penalties for the trustee/s and tax consequences for the fund
• trustees need to make investment decisions for the SMSF that are in the best interests of all members; at the same time, they must understand and comply with the restrictions on investments applicable to SMSFs
• trustees must comply with ATO requirements for SMSFs – failure to do so can lead to a loss of tax concessions for the fund.

Importantly, it can be expensive to establish and manage an SMSF. The fees paid for an SMSF may be more than would be paid to another type of super fund. Each year, an SMSF needs to pay for an independent audit, which must be undertaken by an independent approved SMSF auditor that’s registered with ASIC. An approved auditor will:

• Examine the fund’s financial statements
• assess the fund’s compliance with super laws
• provide trustees with a report
• report any contraventions of the SIS Act to the ATO.

Once the audit has been finalised, trustees need to complete and lodge the SAR by its due date. If the SAR is lodged more than two weeks late, the SMSF won’t be able to receive contributions or rollovers until the SAR is lodged. Once the SAR is lodged, the trustee has to pay any tax liability and the annual supervisory levy.

The supervisory levy is a fee charged by the ATO and is added to the tax return for each SMSF. When the SMSF is assessed for tax, this levy is added to the total payable to the tax office. It is currently $259.

Most SMSFs also pay for additional help, such as:

• preparing the SMSF annual return (SAR)
• valuations of the SMSF’s assets at market value so to prepare the fund’s accounts, statements and SAR; some classes of assets must be valued and reported in a specific way and trustees must have evidence of the valuation available
• actuarial certificates for SMSFs paying income streams (pensions)
• financial advice
• tax advice
• legal fees
• assistance with fund administration
• insurance for members.

Unlike personal tax, the ATO does not send out a tax assessment to SMSFs. Therefore calculating the correct tax is up to the person preparing the return. The return is a comprehensive report on all the SMSF’s transactions and benefit payments.

SMSFs and tax

Each SMSF must be registered with ATO for both an ABN and TFN. If this isn’t done, the SMSF will not be registered as an SMSF and therefore not entitled to tax concessions. Importantly, if unregistered, employers will not be able to claim deductions for contributions they make to the fund.

One of the advantages of the SMSF structure is that like a corporate, SMSFs are deemed to have income (including contributions and investment earnings) and expenses for tax purposes. At 15%, SMSFs have a low tax that can be further reduced by offsetting expenses and other tax credits.

Because SMSFs can control when assets are disposed of, capital gains can be managed in a more targeted way. For example, an SMSF acquires an asset today and it appreciates by 75% by the time its members retire. That asset can then be sold to provide income to the complying pension stream with nil tax paid on the realised capital gain of the asset.

The adaptability of SMSFs enables trustees and their advisers to optimise tax efficiency for its members. By tailoring strategies to the individual circumstances of members, and leveraging options such as contributions, reserves, and distributions, trustees can mitigate overall tax liabilities within the fund. In contrast, within pooled superannuation fund, personal circumstances cannot be factored in as members have to be treated consistently.

The SMSFs structure also provides flexibility when it comes to managing taxable liabilities. An SMSF requires only one tax return despite potentially having up to six members. If the fund includes retired members who are tax-exempt, while others remain subject to a 15% tax environment, strategic allocation of earnings from the tax paying members to the retired members can yield tax advantages.

Income tax

The income of an SMSF is generally taxed at a concessional rate of 15%. To be entitled to this rate, the SMSF has to be a ‘complying fund’ that follows the laws and rules for SMSFs. For a non- complying fund, the rate of tax applied is the highest marginal tax rate.

Contributions

Certain contributions received by a complying SMSF are included in its assessable income and are usually taxed as part of the SMSF’s income at 15% (or 47% for non-complying SMSFs). These ‘assessable contributions’ include:

• employer contributions (including contributions made under a salary sacrifice arrangement)
• personal contributions that the member has notified the trustee they intend to claim as a tax deduction
• generally any contribution made by anybody other than the member, with limited exceptions such as spouse contributions and government co-contributions^[2].

These contributions are taxed in the SMSF as income, but at the concessional rate of 15% up to the contributions cap. The cap is currently $27,500 per year and is increasing to $30,000 at 1 July 2024. The non-concessional contribution cap, currently $110,000 will increase to $120,000 from the same date.

If a member fails to provide their TFN, the SMSF will have to pay additional tax on their mandated employer contributions and cannot accept other types of contributions. The additional tax rate is 34% for complying SMSFs and an additional 2% (for a total of 49%) for non-complying SMSFs.

The difference in the treatment of contributions between super funds and SMSFs is significant. Because contributions to SMSFs are treated as income, tax is levied once the expenses of the SMSF have been deducted.

Earnings

An SMSF in the accumulation phase will have its income earned from investments taxed at 15%. Franked dividends paid by an Australian company may entitle the SMSF to a tax credit, which will reduce its overall income tax liability. As with income received from contributions, income derived from earnings will be taxed on an after expenses basis.

Non-arm’s length income (NALI)

SMSFs must always transact on an arm’s-length basis. The purchase and sale price of fund assets should always reflect the true market value of the asset and the income from assets held by an SMSF should always reflect the true market rate of return. Any non-arm’s length income (NALI) is taxed at the highest marginal rate.

The ATO judges income to be NALI for a complying SMSF if it is:

• derived from a scheme in which the parties weren’t dealing with each other at arm’s length
• more than the SMSF might have been expected to derive if the parties had been dealing witheach other at arm’s length.

For example, the ATO considers income derived by an SMSF as a beneficiary of a discretionary trust to be NALI, as are dividends paid to an SMSF by a private company (unless that dividend is consistent with arm’s-length dealing).

NALI also includes income derived by an SMSF from a scheme where the parties weren’t dealing with each at arm’s length and where the fund incurred lower expenses in deriving that income than would be expected if the parties were dealing on an arm’s-length basis.

GST

Most SMSFs don’t need to register for GST although those with an annual GST turnover of more than $75,000 must register for GST. Annual GST turnover doesn’t include contributions, interest and dividends or residential rent or income generated outside Australia. It does include gross income from the lease of equipment or commercial property.

Capital gains tax

An SMSF capital gain is any profit made from selling an asset. It’s classed as income and taxed as such. Similarly, any loss made from selling an asset is deemed a capital loss. Both need to be included in the SMSF’s annual return to the ATO.

Because capital gains are treated as regular income and an SMSF’s income is taxed at the concessional rate of 15%, capital gains are also subject to a 15% tax.

If an asset has been held for more than 12 months before it is sold, its capital gain may be eligible for a tax discount of 33%. That means, only two-thirds of the capital gain will be taxed – i.e. at the rate of 10%.

A capital loss is not an allowable deduction and can only be used to offset against capital gains. If capital losses are greater than capital gains in a financial year, they must be carried forward to be offset against future capital gains.

If the capital gain is used to fund an income stream (i.e. a member’s pension) then zero tax will be applied to the proportion of capital gain funding the pension.

SMSFs in pension phase

When SMSF income is used to provide a pension stream, there is no tax at all. However, this concession is available only to funds that comply with the ATO’s requirements for SMSFs. For those SMSFs invested in Australian equities, franking credit refunds can be claimed from the ATO for any excess credits.

Investment income received by an SMSF is tax exempt to the extent that those assets are supporting retirement phase income streams. This income is called exempt current pension income (ECPI) and is claimed in the SAR once the SMSF commences payment of one or more retirement phase income streams.

An SMSF is not automatically entitled to ECPI – there are steps that the trustee/s must take to be able to claim it.

SMSFs and property investments

One of the key benefits of an SMSF is the ability to own property. There are two primary advantages to holding property inside an SMSF.

Firstly, there’s concessional tax on rental income; rent received by an SMSF will be taxed at a maximum rate of 15%. Some expenses related to ownership of the property will generally be tax deductible to the fund, lowering the effective tax rate. These expenses include such as rates and property maintenance.

Secondly, superannuation tax rates also apply to a capital gain resulting from an increase in the property’s value. Consequently, depending on when the property is sold, any capital gain the SMSF makes on its sale could be tax-free.

For example, if a median-priced residential property of $667,000 is bought by a typical investor and sold a decade later for double the value, their capital gains tax can be $157,000. If it eventually doubles again in value, the tax bill climbs above $300,000. If that property is held by an SMSF member in retirement, the CGT is zero after age 603..

Case study: Commercial property investment

Matt and Ben are business partners in a successful plumbing business. They’d been at school together, played football together and did their apprenticeship together. As their business grew, they sought financial advice to further develop and grow their business and its profitability.

A key part of the business plan was to establish an SMSF and to purchase a commercial property. To do this, Matt and Ben each rolled their personal super into the SMSF structure. A bare trust was then established to enable the SMSF to borrow additional funds to cover the cost of the property.

The business had been paying rent to a landlord for a commercial premises; it now pays a commercial level of rent to the SMSF. At the same time, Matt and Ben continue their super contributions, split between their original industry fund (to retain insurances) and the SMSF. This ensures the loan is repaid, other expenses can be met and, over time, other assets can be purchased.

The SMSF received a rollover of $220,000 from Matt and Ben and borrowed $400,000 to purchase the commercial property for $600,000. Using a mix of income from rent, contributions and bring- forward contributions, the financial strategy sees the loan being repaid within seven years when it is estimated the asset will be worth $1 million.

In this case, the SMSF would not need to be registered for GST. Although it is receiving rental income from a commercial premises, this income does not exceed $75,000 per annum. Tax liabilities arising from income received from contributions and rent will be offset by the expenses of the SMSF and its property asset.

Conclusion

The unique flexibility of SMSFs empowers trustees and their advisers to tailor strategies that optimise tax efficiency for members. This adaptability allows for a more personalised approach, considering individual circumstances and employing tactics such as contributions, reserves and distributions to minimise overall tax liabilities within the fund. In contrast to pooled superannuation funds where uniform treatment is mandated for all members, SMSFs offer a bespoke solution tailored to each member’s needs.

The streamlined structure of SMSFs simplifies tax management by requiring only one tax return. By leveraging this structure, SMSF trustees can strategically allocate earnings, particularly benefiting retired members enjoying tax exemption. As such, SMSFs not only offer enhanced control and customisation but also deliver tangible tax advantages, cementing SMSFs as a powerful tool for wealth management and retirement planning.

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Notes:
[1] ATO, Quarterly Statistical Report, December 2023
[2] Australian Tax Office