The number of self-managed super funds (SMSFs or more commonly known as DIY funds) continues to grow. As at June 30 this year, there were over 410,000 of them holding over $300 billion in assets. The global financial crisis and the losses it generated for super fund investments has possibly caused many to look into and indeed, start up, a self-managed super fund. Being in control of your own financial destiny sounds good. Just don’t forget there are laws to comply with.
And who oversees compliance with those laws – the ATO.
There is an inherent danger with SMSFs in that they put the owner of a business (often a trustee of the fund) in close proximity to the fund itself. The temptation is great to access the fund when times get tough – and the law may not allow that.
The Tax Office has for some time now been conducting extensive compliance reviews of self-managed super funds. While many are run according to the rules and laws in place, there are some where that is not the case.
The Tax Office says that close to 90% of funds meet their SMSF return lodgment obligations, although it considers that too many still do not lodge on time. SMEs shouldn’t underestimate the implications of not lodging the super fund return on time. Non-lodgment is seen as a contravention of the law and a fund can be made non-complying as a result. That means, among other things, it will lose the tax concessions that attach to being a self-managed fund.
ATO figures show that, at the end of June 2009, there were 219 SMSF convictions for failure to lodge by the due date resulting in fines and costs totaling close to $750,000.
Compliance reviews and audits conducted by the ATO have shown a high percentage of misreporting and calculation errors within SMSF annual returns. It is worth highlighting a few of these in the hope they will help those SMEs that have self-managed funds to avoid making them (and incurring the wrath of the Tax Office!).
Non-arm’s length income
The ATO says non-arm’s length income is being reported incorrectly in many cases.
The main source of error in annual returns is trust codes. A problem arises where an income distribution that had been reported as being from a discretionary trust should in fact have been distributions from a fixed trust.
The ATO has given an example. During the 2001 financial year, a fund entered into an arrangement with two related trusts. The arrangement involved establishing a fixed trust and varying the trust deed of the family trust to enable it to make a distribution to the fixed trust that was subsequently distributed to the SMSF. The family trust, fixed trust and SMSF are all related entities.
The fund would not have received the distributions from the fixed trust in the 2004 and 2005 income years had the above-mentioned arrangement not been entered into. The fund paid no consideration for the units in the fixed trust, yet received distributions of $300,000 and $200,000 in the 2004 and 2005 years respectively.
The ATO considered that the parties to the arrangement were not dealing with each other at arm’s length and the fund received an amount greater than what might have been received had the family trust and fixed trust been dealing with the fund on an arm’s length basis.
Accordingly, the ATO said the trustees had made false and misleading statements on the annual returns for the years in question, resulting in a tax underpayment of $167,500 and penalties of $40,000.
Insurance premiums claims
A self-managed super fund can use a variety of life insurance policies to provide super benefits upon death or temporary or permanent disability of members. There are specific tax deductions for these benefits, one of which is 30% of the premium where the policy is a whole-of-life policy.
In one case the ATO examined, a fund incorrectly claimed the wrong amount for deductions for whole-of-life insurance premiums paid for a member of the fund in the 2002 to 2006 income years. As a result, amendments to the fund’s annual returns were made to reflect the correct amount of whole-of-life insurance premiums being claimed as a tax deduction. The ATO imposed $50,000 in tax shortfall and $12,000 in penalties because it said reasonable care was not taken by the tax agent who prepared the annual returns.
SMSFs are entitled to claim deductions for investment expenses, but the ATO says it is finding they don’t always get this right. Errors can occur due to either overstatement or incorrect claims on the annual return. The most common reason for misreporting, the ATO said, was recording items that were capital in nature (and therefore not deductible) at the incorrect label.
In one instance, the ATO said it uncovered a fund had claimed a deduction of $300,000 for investment expenses during an income year. During the audit, the ATO found this amount represented an investment of $150,000 each in two companies. The fund was acknowledged as an investor/shareholder/creditor in these two companies through liquidator correspondence.
The ATO said the $300,000 represented an amount invested for the purpose of earning income and was capital in nature – therefore no deduction was allowable. The ATO imposed a $45,000 tax shortfall and $11,250 in penalties was imposed.
Other key areas
There are a number of other key areas that SMSFs should keep in mind, eg:
- Sole purpose test: Concessional tax treatment is only provided on the proviso that superannuation is for the sole purpose of providing retirement benefits for their members. For example, trustees who are regular golfers and invest fund moneys in a golf club membership with playing rights attached would raise questions under the sole purpose test.
- Running a business: The Tax Office takes the view that if an SMSF is running a business, it is not being administered for the sole purpose of providing retirement benefits to members and beneficiaries.
- Record keeping: The Tax Office expects minutes to be kept outlining the fund trustees’ investment decisions, how they made those decisions, transaction records, etc.
- Failure to keep assets separate: Self-managed funds need to maintain their assets separately from those of a business in which one or more of the trustees were involved. In some cases, where assets are not in the name of the fund but in the name of one of the trustees, the asset can be exposed to loss if the trustee was declared bankrupt or their business went into receivership.
Know the rules
The Tax Office is sharpening its focus on self-managed super funds. It has for some time being conducting an education campaign about SMSFs and has made a considerable amount of information available on its website. While the ATO considers there have been improvements to compliance across the SMSF sector, it says there is still a way to go and still some serious issues that need to be addressed by trustees and tax agents.
Conducting a self-managed super fund can be a great way for an SME to secure a financial future, but there needs to be caution that the relevant laws are correctly complied with… and that is not always straightforward.
Terry Hayes is the senior tax writer at Thomson Legal & Regulatory , a leading Australian provider of tax, accounting and legal information solutions.
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