Issues in its sights

Accurium head of education Mark Ellem talks to the ATO about where some of the current SMSF compliance issues lie.

AS part of SMSF Professionals Day 2023 –Strategies for Success, Mark Ellem spoke exclusively to ATO SMSF trustee risk and strategy director Kellie Grant about the compliance areas the regulator is targeting and those still causing concern. The following is an extract from this discussion.

Mark Ellem (ME): What are the ATO’s concerns when it comes to super strategies and what raises your interest in respect of super strategies?

Kellie Grant (KG): We have a particular focus on reviewing strategies or arrangements that result in an inappropriate channelling of income into an SMSF to take advantage of the concessionally taxed environment. These schemes often involve the application of the non-arm’s-length income (NALI) tax provisions and sometimes Part IVA antiavoidance provisions.

These strategies typically involve group structures and related-party dealings.

An example of where these arrangements sometimes play out is in the property development space. While an SMSF is not prohibited from investing directly or indirectly in property development, these ventures can involve complex arrangements that can lead to inadvertent breaches of the super laws and serious contraventions.

We strongly recommend trustees read our SMSF Regulator’s Bulletin (SMSFRB) 2020/1, our recently released Taxpayer Alert (TA) 2023/2 and seek independent professional advice before commencing a property development venture or apply to the ATO for advice.

ME: What other types of strategies concern you?

KG: Our Super Scheme Smart web content, soon to be rebranded as Schemes Targeting SMSFs, also outlines some other types of actions we are concerned about. These involve:

Life interest schemes: These involve an SMSF member or other related entity granting legal life interest over commercial property to their fund in order to divert rental income, enabling it to be taxed at a lower rate without full ownership of the property ever transferring to the fund.

Dividend-stripping schemes: The activity here involves stripping profits from a company in a tax-free form by using an SMSF in pension phase. The SMSF will acquire the shares in a related private company usually at less than market value. The company often has significant previously taxed accumulated profits which then get distributed to the fund as franked dividends, the credits for which are then fully refunded to the fund.

Personal services income streams: This is where an individual, with an SMSF often in pension phase, diverts income earned from personal services to the SMSF so it is concessionally taxed or treated as exempt from tax. The individual usually does this by having the client they perform services for remit the consideration to a third-party company or trust that then distributes this income to the fund purportedly as an investment return to the fund in that entity. Sometimes the return of income to the SMSF occurs via a chain of entities. The arrangement and our concerns are outlined in TA 2016/6.

Section 66 schemes: These are schemes set up to avoid the related-party rules regarding asset acquisitions. We are concerned when we come across arrangements involving a number of parties who have entered into agreements which effectively enable their respective SMSFs to indirectly acquire assets like unlisted shares in private companies the parties in question control.

Limited resource borrowing arrangements (LRBA): We are also worried about LRBAs and intra-group lending arrangements that are not on arm’slength terms because they do not meet the requirements of commercially similar products. Often the interest charged is too low and the repayments on the loan aren’t regular or are on generous repayment terms. These inflate SMSF balances and result in significant profits flowing to the fund. Advisers should read our taxation determination and practical compliance guide on safe harbour LRBA terms for SMSFs to help their clients avoid any NALI consequences.

Note: The ATO’s new web content called Schemes Targeting SMSFs has gone live. You can access it via ato.gov.au and search using quick code QC 49657.

ME: Is the ATO still concerned about reserves being used as a strategy to avoid caps?

KG: Yes, we are still concerned about reserves being used to circumvent caps like the total super balance and transfer balance cap measures introduced back on 1 July 2017.

Following the introduction of those elements, we published our SMSF Regulator’s Bulletin SMSFRB 2018/1

– The use of reserves by self-managed superannuation funds, which provides our view on when we would expect an SMSF to have a reserve.

The material makes it clear there are very limited circumstances under which we would expect a SMSF to hold a reserve and they must be used for a specific legitimate purpose. Basically, the only situation where we would expect an SMSF to have a reserve is when it is paying a member one of the legacy pensions.

We have been monitoring the use of reserves by SMSFs since the 2017 measures came into effect and we’ve noticed a decrease in their numbers over the last five years, which is expected as some of the funds paying defined benefit pensions have now wound up.

We continue to monitor the use of reserves with particular focus on any SMSFs reporting a new reserve and the limited use for them. We will closely scrutinise such arrangements and consider the potential application of the sole purpose test under section 62 of the Superannuation Industry (Supervision) (SIS) Act and Part IVA of the Income Tax Assessment Act 1936 (ITAA).

ME: What’s the ATO’s view on a withdrawal and recontribution strategy where the is to move a taxable component to a tax-free component for the member or move benefits from one member of a couple to the other member of the couple to equalise balances and ultimately maximise the fund’s claim for exempt current pension income?

KG: Ultimately, we would need to consider the facts of each case to determine whether there are any issues, such as contravening any tax or super laws, or triggering the antiavoidance provisions of Part IVA.

A key consideration is whether there has been a legitimate payment of a super benefit and subsequent contribution. Reliance on journal entries or other strategies that attempt to change the components of a super interest without actually making any transactions will not be effective and may attract the operation of ITAA Part IVA.

Other factors that may be considered when looking at whether a particular arrangement attracts the Part IVA provisions may include the purpose and circumstances of the recontribution, whether it forms part of an overall retirement income plan, the type and number of amounts withdrawn and recontributed, the resulting tax position and benefit gained by employing the strategy.

Clients can always request a private ruling if they want formal advice on the tax consequences, including the application of Part IVA, to a particular arrangement. They can also request SMSF-specific advice on the application of the super laws.

Trustees should also seek professional advice when considering whether a particular strategy complies with the super and tax laws.

ME: Does the ATO have an update on the issue of SMSFs with a single-asset investment strategy?

KG: Just before I answer this question, I might just remind everyone of the background to this one. So, in August 2019 we sent letters to around 17,000 trustees who we believed were at risk of failing to meet the diversification requirements when formulating and reviewing their investment strategy. This is because 98 per cent of these trustees had a concentration risk in their fund having invested solely in property using an LRBA.

The purpose of the letter was to remind the trustees of these SMSFs that in formulating their investment strategy, they must comply with the requirements of SIS regulation 4.09. This requires them to have considered diversification and the risks associated from a lack of diversification. The letter was sent to trustees to raise their awareness of their legal obligations and to update their investment strategy if necessary. At around the same time we also updated the content on our website to provide more guidance on what factors the trustee should consider when formulating and reviewing their investment strategy.

To this end, we confirmed that while an SMSF trustee has the ability to choose to invest all of their retirement savings in one asset or asset class such as property, they should be aware this will be bring increased risks such as risks of return, market volatility and liquidity, and that these can be minimised if they diversify by investing in a variety of assets.

They would also need to document in their investment strategy that they had considered the risks associated with a lack of diversification and how a singleasset investment would meet the fund’s investment objectives given the likely return on the investment and the fund’s cash-flow requirements. The trustee’s auditor will then be able to verify compliance with the provision.

Since we sent the letters, we have seen a decrease in the number of regulation 4.09 contraventions that have been reported to us via auditor contravention reports (ACR). So, this would indicate auditors are seeing more compliant investment strategies. I have also received feedback from auditors that trustees are now putting more thought into their investment strategies and hopefully more thought into whether their investments are meeting their retirement objectives.

ME: Do you see many funds invest solely in crypto assets?

KG: No, our annual stats for the year ended 30 June 2021 show that only 1.3 per cent of the overall population of SMSFs for that income year held crypto assets, with the average holding being around $65,000. However, although only a small percentage of funds held crypto during the 2021 income year, this was a 122 per cent increase from the 2020 income year where 0.6 per cent of funds held crypto assets, with the average investment being $33,000.

So, while investments in crypto assets by SMSFs are increasing, those funds that hold these assets still form a small percentage of the overall sector population.

However, we are beginning to see some concerning trends in crypto investments through ACRs and voluntary disclosure reporting.

In the 2021/22 financial year the types of voluntary disclosures we received involved separation of fund asset contraventions, where wallets were not in the fund’s name, and market valuation issues. Along with section 62 breaches of the SIS Act, these were also the most commonly reported breaches identified in ACRs.

However, in the 2022/23 income year to date, we are now seeing more voluntary disclosures in relation to SMSFs losing crypto assets through scams, theft or fraudsters hacking into their accounts. Further, we are seeing loss of crypto assets via collapsed platforms, lost passwords and therefore accounts become locked.

Approximately 70 per cent of the voluntary disclosures are being received for funds for which the youngest fund member is in the 30 to 49 age category.

So, we stress trustees need to be mindful of these risks when considering making investments in crypto assets and should seek professional advice before doing so.

ME: Is there anything else you would like to update us on?

KG: Yes there is. I’d also like to use the opportunity to mention we recently updated our SMSF rollovers web content following consultation with industry stakeholders. The aim of the updates was to provide more detail around how a trustee needs to prepare themselves for making a rollover via superstream.

I should point out the rollover relief we commenced in March last year also ends on 30 June. This means trustees can no longer call the ATO to ask for an extension where they are experiencing difficulties in finding a SMSF messaging provider that provides rollover services for SMSF to SMSF and SMSF to Australian Prudential Regulation Authority fund transactions.

They will now be required to use SuperStream or their auditor will need to report a SIS regulation 6.17 contravention in the ACR where appropriate. The auditor should provide reasons as to why the trustee could not comply with the SuperStream requirements in the free text as we will still take into account reasons provided when determining the application of any penalties.

I also want to finally mention later this year we will release our third and final life-cycle publication on running a SMSF. We have received positive feedback from industry on the usefulness of these publications for both SMSF professionals and their clients and recommend you provide all new and existing trustees with these publications.

The full interview has been made available to attendees of SMSF Professionals Day 2023 and can be accessed via the on-demand option for the event.