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Timing opportunities to utilise shares as contributions for SMSFs

SMSFs may be able to utilise planning opportunities for shares through the in-specie contribution process and create a better tax environment for the fund position, according to a wealth adviser.

In a recent update, Creation Wealth director Andrew Zbik said that while the market volatility and uncertainty during the past year and a half of COVID-19 have many share investors understandably rattled.

However, this may present a smart opportunity for investors nearing retirement in the next five years.

“The benefits of this strategy are that you can continue to hold your shares and move the ownership of that holding into the superannuation environment which has a lower tax rate compared to many investors’ marginal tax rate,” Mr Zbik said.

“Plus, if the shares are being transferred at a price lower than what you paid for them there will be no capital gains tax payable.”

Most superannuants are able to draw an account-based pension from their superannuation fund tax free. However, Mr Zbik said the SMSFs needs to consider that making an in-specie transfer of shares from your own name to your superannuation fund is a capital gains event. This means that if you are transferring the shares at a higher value than what you purchased them you may need to pay capital gains tax.

“If you are transferring the shares at a loss, it means you will retain that loss on your tax return which can be used to offset future capital gains,” he noted.

“So, for some, it may be an opportune time to contribute these shares to your superannuation fund to allow future gains to be made in a concessional tax environment that is superannuation.”

Furthermore, funds must choose a date that the transfer is to take place, properly report the true value of the share on that day as your sale/purchase price and the share registry must be notified of this transfer within 28 days, according to Mr Zbik.

Transferring shares into superannuation will also most likely count towards your non-concessional contribution cap which is currently $110,000 for this financial year or $330,000 if you bring forward three years of contributions and you are aged under 67.

“Ultimately, one would only use this strategy if they anticipate to continue holding these shares for the long-term,” Mr Zbik explained.

“Most members of SMSFs will be able to use this strategy. Some retail superannuation funds will accept shares as an in-specie contribution. Unfortunately, most industry funds are not able to receive in-specie contributions of shares yet, but several are investigating this as an option in the future.”

Source: SMSF Adviser

Can an SMSF own employee shares?

Employers are turning to alternative methods of rewarding employees as wage freezes become commonplace during the pandemic. With record-low wages growth of 1.4 per cent over the last year, companies are offering employee share schemes (ESS) as an incentive where they struggle to pay high salaries.

The question is: can an SMSF own employee shares?

Essentially, a member can transfer an asset owned personally into an SMSF through an in-specie contribution. The limiting factors include the exceptions outlined in section 66 SIS – acquisition of assets from a related party, the contribution caps and non-arm’s length income (NALI).

Acquisition of assets from a related party

In general, the transfer of share or options from an employee participating in an ESS is an acquisition of assets from a related party. The reason is that the employee is typically a related party to the fund.

The fund must acquire the assets at market value, either in a listed security or in a related entity, with the maximum investment as a percentage of total fund assets shown below:

Asset Type

Max SMSF Investment

Listed Security

100%

Unrelated Shares/Units

0%

Related Shares/Units

5%

To be clear, an SMSF cannot acquire ESS shares in an unrelated private company and is limited to a maximum investment of 5 per cent of the total value of fund assets in a related party entity ESS under the in-house asset limits.

Regardless of the discount or method applied to price the ESS for the employees, the acquisition price from the SMSF’s point of view is the market value when the shares are transferred into the fund.

While it is easy to determine the market value of shares listed on the ASX, the market value of shares in a related, unlisted entity is complex and requires more documentation.

Suppose the shares or options are transferred in for no consideration or less than market value? Where the member takes up the difference as a contribution, the shares are acquired at market value, and section 66 SIS will be satisfied.

Contribution caps

The ATO expects SMSF trustees to know which types of contributions breach the super laws. Returning a contribution is only allowed where the trustee cannot accept the amount under SIS or where the return is authorised by the principles of restitution for mistake — not where the member has exceeded their caps or simply changed their mind.

By way of example, a member is 45 years of age and received $25,000 in employer contributions during the year. She is offered an ESS from her employer, a publicly listed company, with a total market value of $35,000. However, her total superannuation balance (TSB) is above $1.6 million as of 30 June the previous year.

As a result, the member cannot make any more contributions because the concessional cap has been reached, and the non-concessional contributions cap is nil.

In this case, however, the member makes the $35,000 non-concessional in-specie contribution to the fund of the ESS on 2 June 2020.

However, it is not until 12 months later, during the audit, that the trustee is made aware that the member breached its contribution limits.

The ATO’s position is straightforward. A reasonable trustee, acting with the level of care, skill and diligence required of a trustee of a complying fund, would have checked the fund’s affairs.

Because the member is also a trustee, the fund effectively becomes aware of whether it can accept the contribution or not when it happened.

There is a strict process to follow as excess contributions cannot be refunded immediately. Technically, this is illegal early access: the member must wait for the ATO to issue an excess contributions determination notice before returning the extra amount.

Ownership of ESS

Some ESS include terms and conditions such that only the employee can own the shares. Others have the requirement that the employer must approve any transfer of the shares to an associate, related party or entity.

Under these circumstances, it may be difficult for the fund to own the shares beneficially.

Depending on the details of the offer, the fund may not be able to legally hold the shares, a potential breach of r4.09A SIS.

Remember, too, that an asset is generally considered a contribution when the SMSF gets legal ownership of the asset.

NALI

There may be other circumstances that contribute to the transfer of the ESS into the fund not being on an arm’s length basis.

The offer could include more favourable terms such as an interest-free loan from the employer to purchase the shares or receiving a higher dividend instead of market remuneration.

The SIS rules state that where parties are not dealing at arm’s length and the terms are more favourable to the SMSF, there will be no breach of s109 SIS. 

However, the NALI provisions then apply, which remove the fund’s tax concessions where the SMSF and other parties are not dealing at arm’s length in relation to a scheme.  

Where income is deemed to be NALI, all of the income generated from that asset will be taxed at the top marginal tax rate of 47 per cent, even if the member is in the pension phase.   

Conclusion

There is a lot to consider when a member transfers ESS into an SMSF by way of an in-specie contribution. The trustee must ensure the transaction meets the requirements of s66 SIS by assessing the facts and circumstances of each situation.

The federal government has recently made ESS more attractive by removing the cessation of employment as a taxing point in the May 2021 budget. While the proposal is awaiting royal assent, this advantageous change may see more ESS transferred into SMSFs by members.

SMSF professionals need to pay close attention to the finer details of the ESS offer to ensure any in-specie contributions are in line with SIS, which will then allow an SMSF to own employee shares.

Shelley Banton, head of education, ASF Audits
Source: SMSF Adviser 

SMSF scams are on the rise: Here’s how to fight back

The growing prominence of SMSFs has made them a ripe target for scammers.

More and more Australians are opting to forge their own future with a self-managed super fund.

According to the Australian Taxation Office, self-managed super funds (SMSFs) have continued to grow in value and popularity in recent years. Their latest numbers indicate that there are 593,000 SMSFs in Australia, accounting for approximately $733 billion in total assets.

“SMSFs had assets of over $1.3 million each on average in 2018–19, up by 5 per cent from the previous year and up by 22 per cent over five years,” the ATO said.

One report by IBISWorld suggested that SMSF assets made up almost a quarter — 24.7 per cent — of total super assets as of March 2020.

However, with that popularity has come new hazards for investors.

ASIC issued a fresh warning for SMSF scams back in May, recommending that investors undertake independent enquiries to ensure that the scheme is legitimate if they are contacted by a person or company encouraging them to open an SMSF and move funds.

“Investing in financial products always involves some level of risk, but it is also important to check that investment opportunities are legitimate before investing,” they said.

Speaking to sister title nestegg, Marisa Broome, the chair of the Financial Planning Association, reiterated the classic phrase: if it looks too good to be true, it probably isn’t.

“In a record-low interest rate and post-COVID environment, investors need to remain vigilant and not be tempted by supposedly attractive but questionable offers,” she said.

Ms Broome cautioned that while self-managed superannuation funds can be “a key strategic structural option” for many investors, they are “not for everyone”. 

“They are complex, need active involvement by the members, and can be costly — both in actual fees and lost investment earnings if not managed well,” she said.

In her experience as a financial planner, Ms Broome said she has seen many examples of poor investments where investors are encouraged to set up costly structures within their SMSF to borrow funds. 

These funds are then used to buy property “that is often overpriced, poorly located and possibly may result in a large commission being paid to the ‘introducer’ that is not disclosed to the client”.

Ms Broome said that while ASIC does put out alerts on investment scams, “many of these schemes do fly under the radar”.

“Some may even technically meet all the requirements of the law, but what they are actually selling is an investment that will never provide the promised returns,” she said.

“Seeking advice from a qualified financial planner will help in many areas, including to help you differentiate between a scam and a legitimate offer.”

Source: SMSF Adviser

Balancing discretion and direction approaches for death benefits

With the increasing number of court cases involving death benefits in SMSFs, greater care should be placed in evaluating discretion or direction approaches when it comes to death benefits.

With increasing disputes and legal battles around money and SMSFs, particularly among siblings when their parents have passed, numerous court cases could be potentially avoided with better planning, and the focus also weighs in the ideal approach to reduce the risk of client estate planning errors.

In a recent TopDocs technical webinar, TopDocs head of training Michael Harken said, as time has gone by, advisers preferences have moved constantly between trustees having discretion or direction when it comes to how death benefits are going to be applied.

Mr Harken noted that, in prior years, the thinking was that with the BDBNs lapsing after three years, there might not be so much value in putting them in place and it may be better to maintain discretion with the trustee at the time.

“However, the issue with discretion has sort of popped up a little bit more favourably of recent times since the introduction of the transfer balance cap on 1 July 2017,” he said.

“The reason for that is it provides flexibility to determine based on the circumstances applicable at the time whether the benefits should be or can be paid as a pension, and if they can, how much can be paid and whether other money should pass to individuals as a lump sum, or to the estate and then possibly to go into super proceeds trust or a testamentary trust.

“Those decisions where there’s a discretionary aspect can be made at the time based on the circumstances.

“Whereas if we go back to the direction approach, it’s all going to depend because the quality of the documentation is going to have a bit of a bearing on whether the direction was good or bad, effective or not, and a lot of the cases fall into those areas.”

Mr Harken said that advisers should consider that, basically, all of the estate planning documentation and including wills must complement each other because, if they don’t, there are higher chances to enter into conflict situations that bring about legal action.

“If they are complementary, it goes a long way to removing any potential conflict,” he noted.

“When it comes to conflict, advisers need to note that the conflict can come from the competing interests that are looking for some money from the deceased benefits, and there are issues that arise from that and particularly in relation to where there is discretion.

“But meanwhile, even where there’s direction, the trustee may not act impartially, they may decide to pay themselves and that provides a significant conflict, and effectively, some of the cases have shown us that trustees should not act in a conflict position.”

Even where the deed might provide some authority to the trustee to look after themselves as a first call, Mr Harken noted it may only mitigate the risk and not fully absolve the trustee from looking after themselves.

SMSFs in blended family situations are also very often at risk and it is also because there is no one-size-fits-all approach.

“The competing interests are also generally going to be dissatisfied potential beneficiaries, and they can be an accident waiting to happen,” he said.

“In particular, we note that trustees are subject to very strict duties. These duties include the duty to properly inform themselves.

“Further, trustees must take great care to ensure they exercise discretion in good faith, upon real and genuine consideration, and for the purposes for which the discretion was conferred.

“As advisers, we don’t know what the intentions of the deceased were and that’s where that planning is essential and it can at a larger extent at least cut off any sort of uncertain claims in the future.”

Source: SMSF Adviser

End-of-financial-year essentials for SMSF trustees

As the end of the financial year approaches, it is a good time for trustees to do an annual check-up on their Self-Managed Super Fund.

Here are five key issues to be aware of in the 2020-21 tax year.

Contributions

Non-concessional (after-tax) contributions are limited to $100,000 (or a maximum of $300,000 if you satisfy the non-concessional contributions bring-forward rule) and concessional (before-tax) contributions are limited to $25,000. These limits will be indexed on July 1 and increase to $110,000 for non-concessional contributions ($330,000 under bring-forward rule) and $27,500 for concessional contributions.

The non-concessional contributions bring-forward thresholds do not increase if you have already triggered a bring-forward period that has not ended by June 30.

To make sure you do not accidentally trigger the bring-forward arrangement, you need to consider all your non-concessional contributions made to all your superannuation funds. Unreleased excess concessional contributions also count towards the non-concessional contributions cap.

Before June 30, it is important to review contribution strategies to ensure you have contributed what you intended to, and ensure you are below the contribution caps.

In the 2020-21 financial year you may also be eligible, subject to your Total Super Balance (TSB), to make larger concessional contributions – if you have any unused concessional contribution cap space from the 2018-19 or later financial years.

Where you have made personal contributions and intend to claim a tax deduction in 2020-21, it is important that you check all employer contributions and salary sacrificed amounts to super to make sure you do not breach the annual concessional contributions cap.

Investment strategy

It is important to understand that an SMSF’s investment objectives and strategy are not set in stone.

Trustees should regularly review the investments of the fund, investment risk, likely returns, liquidity, insurance and cash flow requirements as well as the diversification of investments.

Before any investment decision is made, you should examine the impact it would likely have on the overall portfolio, to ensure you are investing in line with your investment strategy.

Minimum pension payments

To help manage the economic impact of the coronavirus pandemic, for the 2019-20, 2020-21 and 2021-22 tax years, the federal government has reduced the minimum drawdown requirements by half for account-based pensions and market-linked pensions. There is still time to consider and, if required, amend your pension payments for 2020-21.

Where you have continued to receive regular pension payments, it is likely you may have received more than the required minimum amount. Unless you meet contribution eligibility rules, these funds cannot be returned.

Where you have restructured your pension withdrawal amounts, it is important to ensure that you do not underpay the minimum pension payment required. Where this requirement is not met, a SMSF may be subject to 15 per cent tax on pension investments, instead of them being tax free.

Valuing assets

SMSF trustees are required to value the fund’s assets at market value on June 30 each year when preparing the fund’s financial accounts.

Ensuring that member benefits are shown at market value is important when calculating each member’s TSB. This number is used to determine what, if any, non-concessional contributions can be made without exceeding your non-concessional contributions cap, and when determining your eligibility to make catch-up concessional contributions and receive government co-contributions.

If you are starting a pension, it is important to value your pension balance correctly to ensure you do not begin a pension with a balance exceeding the Transfer Balance Cap. For the 2020-21 income year, this cap is $1.6 million and will increase to $1.7 million on July 1, in line with indexation.

Lodgement obligations

All SMSF trustees are expected to work with their tax agent or accountant to ensure that they meet all their lodgement requirements on time.

While the current economic conditions due to COVID-19 may make keeping up to date with your trustee obligations a challenge, access to the ATO’s early engagement and voluntary disclosure service is available to assist you to get your affairs in order.

Missing your annual return lodgement due date could result in the status of your SMSF changing on the ATO’s Super Fund Lookup, which could restrict your SMSF from receiving super guarantee payments, as well as some rollovers.

Written by John Maroney, CEO, SMSF Association

SMSFs and 50/50 unit trusts

There is an increasing number of SMSFs that invest in 50/50 unit trusts. That is, an SMSF has a 50 per cent interest in a unit trust, with another unitholder holding the remaining 50 per cent interest, which invariably is an unrelated SMSF.

Our experience over the years has uncovered weaknesses in how many of these have been implemented, operated or documented.

We examine below some key risks that should be considered and strategies for successfully navigating this trust structure.

Is the trust a related trust?

Where there are two unrelated SMSFs each holding 50 per cent of the units in a unit trust, this “arrangement” has generally been considered not to give rise to a related trust for in-house asset purposes under s 70E(2)(a) of the Superannuation Industry (Supervision) Act 1993 (Cth) (SISA).

However, there are several other tests that can easily give rise to a related trust relationship and related follow on consequences as discussed below.

The primary consequence of the related trust relationship is that once this relationship arises, the in-house asset rules limit each fund’s investment to no more than 5 per cent of the market value of each fund.

ATO materials regarding 50/50 unit trusts

The ATO in March 2013 confirmed in its ATO National Tax Liaison Group – Superannuation Sub Committee Minutes of 5 March 2013 (ATO NTLG Minutes) that an SMSF holding a 50 per cent interest does not, by itself, amount to control of a unit trust. These non-binding ATO comments have been relied on by many without realising that the ATO did not rule out the other tests in s 70E(2) such as s 70E(2)(b) and (c).

Section 70E(2) provides three limbs to test whether a unit trust is a related trust.

(2) For the purposes of sections 70B, 70C and 70D, an entity controls a trust if: 

  • a group in relation to the entity has a fixed entitlement to more than 50 per cent of the capital or income of the trust; or 
  • the trustee of the trust, or a majority of the trustees of the trust, is accustomed or under an obligation (whether formal or informal), or might reasonably be expected, to act in accordance with the directions, instructions or wishes of a group in relation to the entity (whether those directions, instructions or wishes are, or might reasonably be expected to be, communicated directly or through interposed companies, partnerships or trusts); or 
  • a group in relation to the entity is able to remove or appoint the trustee, or a majority of the trustees, of the trust.

More than 50 per cent of units

The test in s 70E(2)(a) relies on whether a group (e.g. the member and the member’s related parties) has a fixed entitlement to more than 50 per cent of the capital or income of the trust.

This requires more than a 50 per cent holding of units. Therefore, a 50 per cent or lesser holding does not give rise to a related trust relationship under s 70E(2)(a). This test is generally relatively easy to establish from the unit trust documentation and related records if all units are of the same class of units.

In reviewing a trust deed, however, you need to carefully review the provisions of each deed in detail and should not make any assumptions on what, for instance, you might expect to find in the document. As noted by the High Court in CPT Custodian Pty Ltd v Commissioner of State Revenue (2005) 224 CLR 98 at [15]:

In taking those steps, a priori assumptions as to the nature of unit trusts under the general law and principles of equity would not assist and would be apt to mislead. All depends, as Tamberlin and Hely JJ put it in Kent v SS “Maria Luisa” (No 2), upon the terms of the particular trust. The term “unit trust” is the subject of much exegesis by commentators.

However, “unit trust”, like “discretionary trust”, in the absence of an applicable statutory definition, does not have a constant, fixed normative meaning which can dictate the application to particular facts of the definition in s 3(a) of the act.

If there are different classes of units, for instance, a detailed analysis would need to be undertaken to see which unitholder may exert more influence or control.

Sufficient influence

The second test in s 70E(2)(b) that can result in a related trust relationship is what is broadly known as the “sufficient influence” test. The ATO comments on the 50/50 unit trust question in the 2013 NTLG Minutes were qualified s 70E(2)(b) stating that:

… the trustee of the trust … might reasonably be expected, to act in accordance with the directions, instructions or wishes of a group in relation to the entity …

Until recently, there has been little guidance on the sufficient influence test in s 70E(2)(b). SMSF trustees involved in 50/50 unit trusts have generally tried to minimise any “related trust” risk. Some instances that may indicate some influence might include:

  • The unit trust deed provides one unitholder a discretion, power or advantage over the other unitholder.
  • The constitution of the corporate trustee to the unit trust provides one director/shareholder with power or advantage over the other director/shareholder, e.g. the chair of a directors or shareholders meeting has a casting vote.
  • One unitholder and/or a related entity, for example:
    • is actively involved in managing and controlling the unit trust’s affairs and the other is relatively passive; or
    • provides loans to the unit trust and has influence via the loan agreements or mortgage or security arrangements in relation to the unit trust.

Recent developments in case law and ATO materials now, however, provide better guidance on what is meant by sufficient influence.

The BHP Billiton Limited v FCT [2020] HCA 5 decision considered “sufficient influence” for the purposes of identifying “associates” of a company under s 318 of the Income Tax Assessment Act 1936 (Cth) (ITAA 1936). The High Court held that BHP Billiton Limited sufficiently influenced BHP Billiton Plc (and vice versa). Further, BHP Marketing AG (the group’s Swiss marketing entity owned 58 per cent by BHP Billiton Limited and 42 per cent by BHP Billiton Plc) was sufficiently influenced by BHP Billiton Plc and BHP Billiton Limited.

Similar wording is used in s 318(6)(b) of the ITAA 1936 to that in s 70E(2)(b) that relevantly provides:

(6) For the purposes of this section:

  • … 
  • a company is sufficiently influenced by an entity or entities if the company, or its directors, are accustomed or under an obligation (whether formal or informal), or might reasonably be expected, to act in accordance with the directions, instructions or wishes of the entity or entities (whether those directions, instructions or wishes are, or might reasonably be expected to be, communicated directly or through interposed companies, partnerships or trusts); …

The BHP decision held that for a company to be “sufficiently influenced” by another entity under s 318(6)(b), it was not necessary to show “effective control” or a causal link between the entity’s “directions, instructions or wishes” and the company’s actions (as BHP had contended).

The court held that the test could be satisfied if the facts provided a basis upon which to conclude a “requisite degree of contribution” between such directions and actions. The BHP facts broadly involved, among other things, a dual-listed UK-Australian company arrangement where directors had to generally vote in a consistent manner.

While the BHP decision related to a different legislative test in relation to a company and its associates for tax purposes to the test in s 70E(2)(b) of the SISA that relates to a unit trust, the decision is relevant as it provides meaning to the similar legislative text/test. As you will glean from the above legislative extracts, both tests (i.e. s 318 of the ITAA 1936 and s 70E(2)(b) of SISA) largely include similar wording including “directions, instructions or wishes … communicated directly or through interposed companies, partnerships or trusts .

There have also been other recent developments where a company has been taken to be controlled by a person who was not formally appointed as a director. Therefore, the fact that a person is not formally appointed does not preclude that person being in a position of control or sufficient influence.

The power to hire or fire the trustee

For completeness, the third test in s 70E(2)(b) is reliant on who can remove or appoint the trustee, or a majority of the trustees, of the trust. As with the more than 50 per cent of units test in s 70E(2)(a), this test is generally relatively easy to determine by a review of the unit trust’s documentation and related records.

As noted above in relation to the High Court’s comments in the CPT Custodian decision, there is no constant, fixed normative meaning of what a unit trust is, as it depends on the terms in the deed being considered.

In this regard, there are various drafting methods used in relation to who has the power to remove or appoint the trustee, or, in the case of individual trustees, a majority of the trustees, of the trust. Several popular methods that we encounter include:

  • A certain majority of unitholders, e.g. 75 per cent can vote to remove or appoint a trustee.
  • An appointor/guardian/founder or similar person or entity is given the power to remove or appoint a trustee.
  • The current trustee may be given the power to resign, remove or appoint a trustee.

The multi-pronged related trust test

As you will see from the above outline, there are a number of important considerations to review to determine whether a related trust relationship exists in s 70E(2) of the SISA.

There are also a number of less well-known provisions that might prove a trap for young players.

Does the ATO discretion to deem an asset to be an in-house asset?

In short, yes. For example, the ATO has a broad discretionary power to deem an asset (that is not an in-house under the usual tests) to be one under s 71(4) of the SISA.

The ATO relied on this deeming power in Aussiegolfa Pty Ltd as trustee of the Benson Family Superannuation Fund and Commissioner of Taxation [2017] AATA 3013. While the ATO lost in the Administrative Appeals Tribunal, the ATO does have a broad discretion to deem an asset to be an in-house asset.

The ATO actually won a separate case in the Full Federal Court, namely Aussiegolfa v Commissioner of Taxation [2018] FCAFC 122, that resulted in the units in the unit trust in question being held to be an in-house asset. The Full Federal Court decision effectively removed the ability of the Administrative Appeals Tribunal to deem the asset to be an in-house asset, as the Full Federal Court had already determined the asset’s status.

Understanding the risks

Thus, as you will appreciate from the above outline, a 50/50 unit trust faces a number of possible risks. If there is any doubt, timely expert legal advice should be obtained especially as a contravention of the in-house asset provisions can result in serious adverse consequences. For example, a contravention can potentially result in, among other things:

  • significant administrative penalties;
  • an SMSF being rendered non-complying with a significant tax liability; or
  • being imposed and potentially the SMSF directors/trustees being rendered disqualified from ever being SMSF trustees/directors again.

By Daniel Butler ([email protected]), director, DBA Lawyers
Source: SMSF Adviser

 

How to ensure SMSF beneficiaries get their share when a member dies

Ensuring that SMSF funds go where the deceased member wants them to go should seemingly be a straightforward process, but unfortunately, this isn’t always the case.

The deceased’s intentions can be thwarted by conniving beneficiaries attempting to acquire a greater share than that intended. This can also result in the intended beneficiary receiving nothing at all.

So, what can go wrong? There are a number of leading cases which demonstrate how SMSF beneficiaries can be prevented from receiving their fair share. Here are a few of them.

Katz v Grossman

The celebrated case of Katz and Grossman is one of the first to make a big impact when it comes to SMSF beneficiaries. In this case, there was an argument between Daniel Katz and his sister Linda Grossman over who were the trustees and members of their deceased parents’ superannuation fund.

Their father and mother were trustees and members of the SMSF. After their mother died, their father appointed Linda as the other trustee of the fund. Then the father died and just after his death Linda appointed her husband Peter as the trustee of the fund. 

Linda and her husband refused to follow her late father’s non-binding death benefit nomination, which had provided that his membership entitlement be given equally to Linda and her brother Daniel.

Daniel argued that Linda was not validly appointed as a trustee. If the court agreed with him, then all subsequent decisions of the trustee of the super fund would have been declared void.

But the court rejected Daniel’s arguments on the basis that the father did have the power to appoint Linda as a trustee and that Linda had the power to appoint her husband Peter as a trustee. The judgment doesn’t mention the payment of death benefits, but it is assumed that Linda and her husband subsequently resolved to have the super fund pay Linda the whole of her father’s membership entitlement. As a result, Daniel did not receive half the superannuation as was intended by the deceased.

This case demonstrates the need for a binding death benefit nomination and the importance of selecting trustees who will honour the member’s wishes upon their death.  

EM Squared Pty Ltd v Hassan

The EM Squared Pty Ltd v Hassan case demonstrates the importance of a well-written SMSF deed. Without the deed being watertight, there may be loopholes which can be exploited to prevent all SMSF beneficiaries from receiving their share. 

In this case, Morris Hassan and his second wife Margaret established an SMSF during their marriage. In 2005, Morris signed a document entitled “Confidential Memorandum” which stated that upon his death, he wished for his portion of the SMSF to be split equally between his wife Margaret and the children of his former marriage, Jeremy and Jane. A year later, Morris died. His benefits in the SMSF were valued at more than $3 million.

Margaret, the sole surviving trustee, established a company, EM Squared Pty Ltd. Margaret was the sole director and shareholder of the company. EM Squared Pty Ltd was appointed as the trustee of the SMSF. 

Margaret sought legal advice which found that the Confidential Memorandum may not be binding, and she may be within her rights to distribute the entirety of Morris’ benefit to herself rather than dividing it equally between herself, Jeremy and Jane. 

The reason for this was that the SMSF deed had strict requirements for documenting how the entitlements would pass to beneficiaries which the Confidential Memorandum may not have met. In addition, the Confidential Memorandum did not take the appropriate form, and further, it could not be proved that the Confidential Memorandum had been served on the trustees of the SMSF during Morris’ life. 

Margaret applied to the Supreme Court. While the outcome of the case is unknown, the court did find that it was an “entirely appropriate case in which to seek advice and directions”. What appears to be the exploitation of a loophole was considered legitimate and appropriate by the court. 

This case demonstrates the importance of a well-written SMSF deed that excludes unnecessary limitations on a binding death benefit nomination. It is inappropriate for a deed to require that the binding death benefit nomination must be in a particular form or that it must be provided to the trustee during the member’s life in order for it to be binding. 

McIntosh v McIntosh 

The McIntosh v McIntosh case provides an interesting lesson on when superannuation is considered part of someone’s estate and the fiduciary duties of a deceased’s legal personal representative. 

When James McIntosh died in 2013 without a surviving spouse, children or a valid will, the rules of intestacy required that James’ estate be distributed equally between his parents Elizabeth and John — who were long divorced and on bad terms. James’ estate was valued at about $80,000. He also had $454,000 in various super funds. 

Elizabeth was appointed as the administrator of James’ estate. This required her to collect her son’s assets and distribute his estate equally between herself and John. 

Elizabeth applied to James’ super funds to have the entitlements paid to her personally, rather than to the estate. She was named as the nominated beneficiary (via non-binding nominations) for each super fund and they released the money to her. 

John’s lawyers wrote to Elizabeth arguing that the super entitlements should be paid into the estate and then divided equally. Elizabeth’s lawyers responded that superannuation did not form part of the estate. 

The courts found that there was a conflict and that Elizabeth was not meeting the fiduciary duties of an administrator; she had a duty to act in the best interest of the estate and instead she was prioritising her own interests. Elizabeth was required to hand over the super benefits to the estate. 

This case demonstrates the importance of a binding death benefit nomination. Had this existed for Elizabeth, then she would have been recognised as the sole beneficiary. It also demonstrates the importance of having a will. Had Elizabeth been named as the executor in James’ will, the court may have decided differently. 

While this case doesn’t directly involve an SMSF, it is pertinent for SMSF advisers as it demonstrates the importance of binding death benefit nominations, the fiduciary duties of legal personnel and the importance of having a will. 

Wooster v Morris 

The Wooster v Morris case not only demonstrates the importance of a binding death benefit nomination, but also illustrates how they can be vulnerable to exploitation.

In this case, Maxwell Morris and his second wife Patricia were co-trustees of their SMSF. Maxwell had made a binding death benefit nomination that required his entitlement be divided between his two daughters from a previous marriage, Susan and Kerry.

Maxwell’s SMSF entitlement upon his death was approximately $930,000 and Patricia’s entitlement at that time was approximately $450,000. 

When Maxwell died, Patricia appointed her son Nathan as co-trustee of the SMSF. She subsequently established a company, Upper Swan Nominees Pty Ltd, of which she was the sole director and shareholder, and the company was appointed as the corporate trustee. 

On legal advice that Maxwell’s binding death benefit may not be binding as it had not been formally delivered to the trustees during Maxwell’s life (a requirement under the SMSF deed), Patricia did not honour the binding death benefit nomination and instead paid Maxwell’s entire entitlement to herself.

Susan and Kerry took the matter to court. The court found that the binding death benefit nomination was indeed binding. Furthermore, the court ordered that Patricia be personally liable for the legal costs of Susan and Kerry to the extent that the corporate trustee was unable to pay them from its own funds.  In this regard, the corporate trustee was prevented from seeking access to the assets of the SMSF fund to pay for the costs of Susan and Kerry.  

While the court found in favour of Susan and Kerry, they were still tied up in court for many years to obtain what was owed to them. The case also demonstrates that given an executor does not automatically become a trustee of an SMSF, executors don’t have control over SMSF assets. Instead, had Maxwell nominated Susan or Kerry to replace him as trustee of the SMSF, Patricia would have been unable to take the steps she did. 

Ioppolo & Hesford v Conti

The Ioppolo & Hesford v Conti case highlights that superannuation is not considered an asset of an estate — it is dealt with separately. Executors do not have control over SMSF entitlements unless they are appointed as trustees. 

In this case, Francesca and Augusto Conti were the only trustees and members of an SMSF.  

Francesca died in 2010. Francesca’s will stated that she wanted to leave her superannuation benefit of approximately $649,000 to her children and not her husband Augusto; however, at the time, she did not have a valid death benefit nomination in place.

Upon Francesca’s death, Augusto appointed as trustee of the SMSF a corporate trustee of which he was the sole director and shareholder. As a result, the corporate trustee had the discretion to pay Francesca’s entire SMSF entitlement to Augusto, which it did. 

Francesca’s children took legal action as executors of her estate, arguing that they were entitled to be appointed as co-trustees of the SMSF which would have given them control over how the SMSF entitlement was paid. 

The court found that executors are not automatically required to be appointed as co-trustees and that the corporate trustee was therefore entitled to ignore the directions set out in the will. As such, the court did not overturn the trustee’s decision to pay the SMSF entitlement to Augusto. 

This case reveals how important it is to correctly document how an SMSF benefit is to be paid on a member’s death. In this case, had a binding death benefit nomination been created, the outcome may have been very different. It also highlights that executors do not have any control over the distribution of SMSF assets. 

How can we ensure SMSF beneficiaries receive their share?

To ensure that super beneficiaries get their share when a member dies, it’s important to plan for how control of the SMSF will be transferred. It’s important to anticipate any issues and tailor a suitable response. Members should consider whether they can trust that the remaining trustee will respect their wishes when they die. If not, then a new trustee may need to be appointed. 

The SMSF deed should be watertight and a binding death benefit nomination should be created. Having a trustee with an appropriately worded enduring power of attorney can usually ensure that superannuation funds go where the deceased member wanted them to go.

Written by Leigh Adams, Owen Hodge Lawyers
Source: SMSF Adviser 

SMSF asset compliance considerations

Investing in certain asset classes or implementing particular structures to do so can result in additional compliance issues for SMSFs. Mark Ellem, head of education at Accurium, identifies areas where trustees will need to pay extra attention. 

When an SMSF considers acquiring an asset or making a new investment, there are several compliance rules and issues that need to be considered at the time of acquisition. For example:

  • whether the asset can be acquired from a related party,
  • does it fit within the fund’s investment strategy,
  • will the investment be regarded as an in-house asset,
  • does the acquisition meet the sole purchase test, and
  • is the acquisition or investment permitted under the trust deed.

In addition to these considerations at the time of acquisition, the ongoing and potential future compliance and audit requirements should also be factored in when the trustees are weighing up whether a particular investment is one the SMSF should be making. SMSFs can have additional layers of compliance when compared to using other non-super structures when acquiring and holding an asset. These ongoing compliance requirements, potential costs and hurdles should be understood by SMSF trustees prior to purchase.

Let’s consider what these issues are for various types of commonly held SMSF assets.

Real estate

One of the most popular asset types held by an SMSF is real estate, which presents several ongoing compliance issues that SMSF trustees need to be aware of. A few of these are discussed below.

• Year-end market value – The market value of real estate held by an SMSF must be considered by the trustee(s) each and every 30 June. SMSF trustees need to be aware of the potential ongoing costs associated with determining and substantiating market value for real estate. Potential costs include the expense of obtaining an independent valuation or other forms of market-value evidence and additional administration and audit costs for an SMSF owning real estate. The ATO has recently released guidance on the evidence trustees need to provide their auditor to substantiate the market value used in the fund’s financial statements (search QC 64053 on the ATO’s website).

• Leasing real estate to a related party – Where the property is leased to a related party, trustees must ensure it continues to meet the definition of business real property (BRP). There should be an examination of the lease agreement to ensure the terms are being adhered to, including any review of the market of rents and that the rental agreement has not expired. In addition to the initial costs to draft and execute a lease, there would be ongoing costs to extend, renew and vary it. This may include the cost of obtaining an independent assessment of market rental value. Variation to a lease may also be caused by unexpected market conditions, for example, the COVID-19 rent relief measures.

• Residential property – Where the property is residential, the SMSF auditor may require evidence it has not been used by a fund member, relative or related party. This could be brought into question where the property is situated in a popular holiday destination and is rented out as holiday rental accommodation. An SMSF auditor may require the trustee(s) to provide evidence the property has not been used by a related party and that this is provided at each annual audit.

• Charges over the property – The SMSF auditor may wish to conduct a search each audit year to ensure the property has not been used to secure any borrowings, unless permitted. This may incur additional costs for the SMSF.

• Investment strategy – It is not uncommon for an SMSF holding real estate to have no other assets, apart from its bank account. The ATO and SMSF auditors have a focus on funds with single-asset investment strategies to ensure compliance with the requirements under the Superannuation Industry (Supervision) (SIS) Act 1993. SMSF trustees need to be prepared to dedicate time to ensure the investment strategy will stand up to audit scrutiny.

• LRBAs – Real estate held via a limited recourse borrowing arrangement (LRBA) is subject to certain SIS requirements. For example, the property cannot be developed. SMSF trustees need to be mindful of the limitations and restrictions of property purchased using an LRBA.

Units in a non-related unit trust

A common scenario is where two or more unrelated SMSFs hold units in a unit trust and that unit trust acquires an asset, typically real estate. In these cases, each SMSF must not hold more than 50 per cent of the issued units in the unit trust. This, together with other requirements, ensures the SMSF’s investment is not treated as an in-house asset.

• Ongoing assessment of relationships – In addition to an initial assessment to ensure a unit trust is not a related trust of each of the SMSF unitholders, there will be a requirement for an ongoing annual assessment to ensure this remains the case. This would include determining whether there has been any change in circumstances that makes members from different SMSFs related parties. For example, a member from each fund jointly acquiring a rental property together or children of members from each SMSF getting married to each other may mean they become related parties. The trustee should not be surprised if their auditor reviews the structure each and every year.

SMSFs can have additional layers of compliance when compared to using other non-super structures when acquiring and holding an asset.

• Exit plan – It is important when this type of structure is entered into that the SMSF trustees are aware of the potential issues when one of the SMSF unitholders wants to dispose of their units in the unit trust. The assessment of whether the investment is caught by the in-house asset rules is examined from the perspective of each SMSF unitholder. A unit trust may be a related trust to one of the SMSF unitholders, but not another SMSF unitholder. For example, a unit trust is set up with three unrelated SMSF unitholders, SMSF A, SMSF B and SMSF C, each holding one-third of the issued units. SMSF C unitholder wants out and SMSF A offers to buy the units at market value. From a practical perspective, this achieves the desired outcome. However, there is now a significant compliance issue for SMSF A as it now holds two-thirds of the units in the unit trust. As SMSF A now holds more than 50 per cent of the issued units, the unit trust is a related trust of SMSF A and caught by the in-house asset rules. From SMSF B’s perspective, it still holds units that represent less than 50 per cent of the issued units and so the unit trust is not a related trust of SMSF B. Assuming SMSF A’s unitholding value represents more than 5 per cent of the total value of its assets, it will be required to dispose of the excess in-house asset amount by the following 30 June. This may cause issues, particularly where the asset held by the unit trust is the business premises of the business operated by members from one or more of the SMSFs. SMSF trustees in this type of non-related unit trust structure need to have an exit plan prior to executing the acquisition to deal with unitholders wanting to dispose of their interest, either voluntarily or involuntarily, such as when a member passes away.

• Market value – As with real estate, SMSF trustees who hold units in a unit trust, or any other unlisted entity, will be required to determine and substantiate the market value each and every 30 June.

Division 13.3A unit trusts

Another common scenario is where an SMSF acquires an asset via an interposed unit trust that complies with SIS regulation 13.22C in Division 13.3A, commonly referred to as a non-geared unit trust. This type of structure can be used where the SMSF is the sole unitholder or where the fund and a related party are the unitholders. While the unit trust is prima facie a related trust of the SMSF, the SIS provisions exempt the units from being treated as an in-house asset, provided it complies with the requirements of SIS regulation 13.22C.

One of the most popular asset types held by an SMSF is real estate, which presents several ongoing compliance issues that SMSF trustees need to be aware of.

• Checklist of prohibited events – SMSF trustees need to be aware of the consequences where certain events occur after the structure has been established. These events are commonly referred to as 13.22D events and will cause the unit trust to be forever tainted as an in-house asset. A 13.22D event can occur simply through the SMSF buying listed shares with surplus cash. Rectification can be a challenge, as well as costly. The fund auditor will need to assess, during each annual audit, that there have been no 13.22D events.

Overseas assets

Two issues that arise where SMSFs acquire assets overseas, particularly direct assets such as real estate, are ownership and market value. Often local laws prohibit the asset being held by the SMSF and an interposed entity is required to hold the asset as a custodian or nominee, resulting in additional costs. Without relevant documentation, substantiating asset ownership can be a challenge.

Market value is also a challenge and may require engaging a local valuer to provide a market-value report. Again, this may be more expensive than arranging a valuation of a property situated in Australia.

• Language used – Where documents are not in English, translation costs may be incurred so that the accountant and auditor can understand them.

• Foreign currency translation – Where a transaction in relation to the overseas asset is in a foreign currency, there may be additional accounting and compliance costs associated with converting the amounts into Australian dollars and dealing with the related income tax consequences. Further, the SMSF may have an obligation to lodge local foreign jurisdiction returns and pay taxes. Generally, the administration and compliance costs associated with an SMSF owning an overseas asset, such as real estate, will be higher than where the asset is situated in Australia.

Collectables and personal-use assets

The rules for an SMSF owning these types of assets are very prescriptive and are generally seen as a back-door prohibition on SMSFs holding such assets. Commonly, when SMSF trustees are made aware of the ongoing compliance requirements of these types of assets, they decide to acquire the asset outside of their fund.

Forewarned is forearmed

Advice at the time an SMSF acquires an asset, or makes an investment, is important to ensure the superannuation rules are followed, but such advice should not end there. Where SMSF trustees have the knowledge and understanding of the ongoing compliance requirements for different types of asset classes, preparation of the annual financial statements and performance of the annual independent audit can run a lot smoother. It also prompts forward planning to deal with potential future events. In fact, it may even lead to the SMSF trustees deciding not to acquire the asset or make the investment. Educating trustees on these and other asset-type issues can reduce the risk of compliance matters or simply lessen the level of annual audit angst for trustees, their accountants and even the auditor.

Source: smsmagazine.com.au

Can an SMSF claim this as a deduction?

SMSF auditors have been witness to some outlandish expense claims and get frequently asked: “Can an SMSF claim this as a deduction?”

One of the most extraordinary claims was for the cost of a 20,000-litre water tank purchased for a property owned by the fund. Unfortunately, it was a small two-bedroom townhouse that couldn’t accommodate a 1,000-litre tank, let alone a 20,000-litre one.

And while it was purely coincidental that the trustee’s residential address was in a rural area, the expense was quickly identified as a mistake and promptly removed from the fund.

The current COVID-19 crisis has only highlighted more uncertainty, with a recent private binding ruling (PBR) providing additional insight into allowable deductions for SMSF expenses claimed by trustees.

The ATO has said that while PBRs cannot be relied upon by taxpayers, this particular ruling applies to the 2021 financial year where the fund attempted to claim a deduction for the costs of a course and subscription for share trading.

Nature of expenses

The general nature of a deductible expense extends to whether it relates to assessable income or not. Where an expense relates to the gaining of non-accessible income (such as exempt current pension income [ECPI]) or when it’s capital in nature means that it is non-deductible. 

It is also essential to make sure that the expense is in line with the assets and investments outlined in the fund’s investment strategy and also allowed under the trust deed and SIS.

Paragraph 4 of TR 93/17 states that subject to any apportionment of expenditure, the following expenses are deductible:

  1. Actuarial costs
  2. Accountancy fees
  3. Audit fees
  4. Costs of complying with SIS (unless the cost is a capital expense)
  5. Trustee fees and premiums for an indemnity insurance policy
  6. Costs in connection with the calculation and payment of benefits to members
  7. Investment and adviser fees and costs
  8. Subscriptions for memberships paid by a fund to industry bodies
  9. Other administrative costs incurred in managing the fund

General deductions

There is even more confusion about general deductions, which get classified in this way when a specific deduction provision is absent.  

These types of deductions are subject to exclusions that include:

  1. Whether it is incurred in gaining or producing assessable income
  2. Whether it is necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income

According to the ATO website, expenses that fall under this category (unless a specific deduction provision applies) include:

  • Management and administration fees
  • Audit fees
  • Subscriptions and attending seminars
  • Ongoing investment-related expenses

Several other exclusions also apply in understanding whether a general deduction is allowable. An SMSF cannot deduct a loss or outgoing to the extent that it is a loss or outgoing of capital (or of a capital nature) or private or domestic nature. 

Some income tax laws also prevent the fund from deducting an expense as well as where the fund produces non-assessable income, such as ECPI. 

Additionally, a fund cannot claim more than one deduction for the same expenditure and can only claim under the most appropriate tax provision for the expense. 

Investment-related expenses

A very well-debated question within the SMSF industry is whether investment-related expenses are deductible or not. 

The answer is that it’s the exact nature of these expenses which is critical in determining deductibility. 

The focus of the PBR was whether an SMSF could claim a deduction for the reimbursement of the costs of a course and subscriptions for share trading purposes under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997).

The answer from the ATO was a resounding no.

One of the reasons is that subsection 295-85(2) of the ITAA 1997 operates to modify the operation of ordinary income and general deduction provisions so that the CGT rules are the primary code for calculating gains or losses realised by a complying SMSF on the disposal of CGT assets. 

The exception to this treatment includes CGT assets that are debentures, bonds, bills of exchanges, certificates of entitlement, promissory notes, deposits with a bank or other financial institution, or a loan. 

While there is also an exception for trading stock, shares and derivatives of shares are not trading stock because they are covered assets under section 275-105 of the ITAA 1997.

Courses and subscriptions not deductible

Any gains made by an SMSF trading in shares will be assessable under the CGT provisions, and any expenditure regarding courses or subscriptions is capital in nature. 

The costs incurred for the course and the subscriptions relate to specific activities that will only generate capital gains and not ordinary income and are therefore not deductible. 

Additionally, they have not been incurred in the administration, operation or management of the SMSF and are not of the type as referenced in paragraph 4 of TR 93/17.

In particular, the PBR noted that the subscriptions were not for memberships to the Association of Superannuation Fund of Australia Limited and other such industry bodies. 

Based on the information provided, the expenses were not incidental, relevant or sufficiently linked to any of the fund’s trading activities.  

Seminar-type expenses may also not be deductible if the expenditure does not have a sufficient connection with assessable income and is an investment of capital made to prepare for the future commencement of an investment business as found in Petrovic and FCT (2005) 59 ATR 1052, [2005] AATA 416. 

In this case, the taxpayer was denied a deduction in respect of property seminars after it was found that the expenditure was not incidental to his pre-existing rental income. 

Conclusion

Apart from depreciating assets, SMSFs should be claiming fund expenses in the year the trustee incurs them. From a compliance point of view, it is also best practice to have all invoices in the name of the SMSF and to pay them directly from the fund’s bank account.

Where the fund incurs expenses specifically relating to assets that generate capital gains or losses, a deduction cannot be claimed under section 51AAA of the ITAA 1936.

To this extent, the latest PBR makes it clear that trustees are unable to claim a deduction for the costs of courses and subscriptions that relate to share trading activities which are capital in nature. 

Which means that the answer is no, an SMSF can’t claim this as a deduction.

Shelley Banton, head of education, ASF Audits
Source: SMSF Adviser

Investment segregation in an SMSF explained

When advisers hear the word ‘segregation’ in an SMSF context, they typically think of segregation for tax purposes. Broadly, this type of segregation involves calculating a fund’s exempt current pension income exemption for a financial year under the segregated method, with any capital gains (or losses) in respect of ‘segregated current pension assets’ being disregarded.

Segregated current pension assets are fund assets excluding ‘disregarded small fund assets’ that are invested, held in reserve or otherwise dealt with solely to enable a fund to discharge all or part of its liabilities in respect of retirement phase pensions. Most commonly, segregated current pension assets arise where 100% of a fund’s assets are supporting retirement phase pension liabilities under the ATO’s view of deemed segregation.

This article examines a different kind of segregation; namely, segregation for accounting or investment purposes. In broad terms, investment segregation involves fund assets being designated to particular members or superannuation interests, eg, for the purposes of allocating investment returns and capital appreciation. Investment segregation can essentially be thought of as a form of member investment choice that is implemented within an SMSF. Naturally, all SMSFs provide a certain degree of member investment choice by virtue of being ‘self managed’. However, this article draws a distinction between genuine member investment choice and the typical investment approach for SMSFs where there is a general pool of fund assets that do not ‘belong to’ any particular member.

Investment segregation potentially offers unique planning opportunities due to the flexibility it provides in relation to apportioning growth between different member accounts. For example, with an appropriate allocation of assets, investment segregation can be used to ensure that Member A’s account balance grows faster than Member B’s account balance, or it can be used to ensure that Member’s A retirement phase account grows faster than Member A’s accumulation account. Accordingly, this flexibility can be used to provide more tax effective outcomes, including in respect of the $1.6 million transfer balance cap (‘TBC’).

We now examine the relevant rules for implementing investment segregation in an SMSF. The discussion will focus on allocation of investment returns rather than an apportionment of costs.

The fair and reasonable standard

Regulation 5.03 of Superannuation Industry (Supervision) Regulations 1994 (Cth) (‘SISR’) provides that trustees must determine how investment returns are to be credited or debited to a member’s benefits in a way that is fair and reasonable as between all the members of the fund and the various kinds of benefits of each member of the fund. There is an equivalent rule in relation to charging of costs (see reg 5.02 of the SISR).

This begs the question: what does ‘fair and reasonable’ require? In the context of the usual pooled investment approach, SMSF trustees generally distribute investment returns in accordance with the existing proportions of member benefits in the fund, subject to the terms of the SMSF deed. Naturally, the ‘fair and reasonable’ standard would require adjustments to be made where there are other variables at play, such as new members being admitted or members ceasing membership during a financial year.

The ‘fair and reasonable’ standard allows for departures from the pooled approach where there is a segregation of member investments in place. For example, under such a strategy, Member A could pick certain assets for investment purposes and it would be entirely consistent with the fair and reasonable standard if the investment returns on those particular assets were credited to Member A’s account.

What does the ATO say?

The ATO acknowledge on their website that investment segregation is allowable (‘Super changes – frequently asked questions’ https://www.ato.gov.au/Individuals/Super/In-detail/Super-changes—FAQs/ (QC 51875)):

Where my SMSF cannot use the segregated method to claim ECPI (exempt current pension income), can I still segregate assets for investment returns?

The change which limits an SMSF from using the segregated method only relates to the ability for that SMSF segregate for the purposes of claiming ECPI. So in these cases, even though the SMSF may be required to use the proportionate method to calculating its ECPI, the trustee can still decide which assets will support pension accounts. In essence, the returns on the segregated assets would continue to be allocated to the respective pension account(s) and the allocation of any tax would be done proportionately.

The above commentary from the ATO makes it clear that the rules in s 295‑387 of the Income Tax Assessment Act 1997 (Cth) that preclude certain SMSFs from using the segregated method for claiming exempt income does not preclude such funds from using investment segregation.

Other relevant considerations

The governing rules of the SMSF should allow for investment segregation and the investment strategy of the fund should be appropriately drafted to reflect the principles of member investment choice.

A fund’s investment strategy documentation is also important for a host of other reasons. For instance, in SMSFR 2008/1 [13], the ATO state that if the activities and investments of an SMSF are undertaken in accordance with the fund’s investment strategy, this is a factor that weighs in favour of the conclusion that the SMSF is being maintained in accordance with the sole purpose test. Additionally, under s 55(5) of the Superannuation Industry (Supervision) Act 1993 (Cth) (‘SISA’), SMSF trustees can be afforded a defence against damages when acting in accordance with the fund’s investment strategy and other applicable SISA covenants, including having regard to investment choice (see s 52B(4) of the SISA).

How can this be used?

As explained below, investment segregation may assist in managing a member’s TBC.

The TBC is a cap on the value of assets which can be transferred into tax-free retirement phase. As the TBC is measured through a static system of debits and credits, growth above that cap (ie, $1.6 million limit as indexed) is not tested and does not trigger an excess transfer balance.

Segregation of investment returns provides an opportunity to pinpoint allocation of growth on an asset-by-asset basis, assuming that asset returns and growth can be accurately predicted. For example, if a well-performing parcel of shares is linked to a member’s pension account, that pension can benefit from the growth in the shares (eg, due to large dividends being paid and the share price increasing) without impacting the member’s transfer balance. Take the following example:

Example

Mr and Mrs Renner are members of the Renner Family SMSF. On 1 July 2018, Mrs Renner turned 65 and commenced a pension. Due to the fund adopting investment segregation, it is agreed that the asset supporting the pension is real estate in the fund valued at $1.6 million. Assume that minimum the annual pension payment is made each year in respect of the pension.

Due to decent rental returns and capital appreciation on the real estate, Mrs Renner’s pension account balance increases to $1.85 million by 30 June 2021 which provides a better outcome for her TBC than if she had merely received a proportion of overall fund growth.

Naturally, appropriate records should be retained in relation investment segregation — ie, based on an appropriate and regularly reviewed investment strategy that provides a proper basis for investment segregation.

Moreover, it should be borne in mind that if investment segregation is maintained solely for tax purposes, the ATO may seek to apply the general anti-avoidance provisions in pt IVA of the Income Tax Assessment Act 1936 (Cth), ie, if the sole or dominant purpose of the segregation is to obtain a tax benefit.

Conclusion

If implemented appropriately and authorised under the SMSF’s governing rules, investment segregation can offer unique planning opportunities for SMSF trustees and advisers due to the flexibility it provides in relation to apportioning growth between different member accounts.

Expert advice should be obtained before implementing investment segregation.

*           *           *

This article is for general information only and should not be relied upon without first seeking advice from an appropriately qualified professional. The above does not constitute financial product advice. Financial product advice can only be obtained from a licenced financial adviser under the Corporations Act 2000 (Cth).

Source: DBA Lawyers