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NTLG Superannuation sub-committee submissions

Editor: The NTAA represents its members' interests in many tax forums. The following are five superannuation issues that Andrew Gardiner raised at a meeting of the Superannuation Sub-committee of the NTLG – National Tax Liaison Group.

Special income and capital gains

By way of background, a self managed superannuation fund ("SMSF") must treat income that it derives in its capacity as a beneficiary of a trust estate (other than by virtue of holding a fixed entitlement to the income) as special income.

In these circumstances, the special income is taxed at 47% – S.273(6) of the ITAA 1936.

Strangely, the wording of S.273(6) only deals with income distributions that are received by an SMSF from a non-fixed trust estate, and the concept of what represents "income" for the purposes of S.273 is not defined within the ITAA 1936.

It is therefore our understanding that the special income provision in S.273(6) only applies to "income" distributions from a non-fixed trust estate as defined under normal accounting and tax principles.

As such, the NTAA submits that a capital gain (within the meaning of Chapter 3 of the ITAA 1997) that is distributed by a non-fixed trust to an SMSF would not be subject to the special income provisions because the distribution does not represent "income".

This is because the distribution from the trust remains "capital" despite the fact that the amount may be taxable in the SMSF by virtue of the capital gains tax measures.

Furthermore, all of the wording that is contained within S.273 which deals with special income applying to distributions from trust estates (whether fixed or non-fixed) also refers to income distributions.

It is therefore conceivable that any taxable capital distributions that are made by a trust to an SMSF are not caught by the special income provisions because the amount being received by the SMSF does not represent "income" for these purposes.

The NTAA seeks clarification on whether the ATO would apply the special income provisions that are contained within S.273 to taxable capital gain distributions that are made from a trust (whether fixed or non-fixed) to a complying SMSF.

ATO Response

The ATO disagrees with that interpretation and relies upon the comments in Draft Taxation Ruling TR 2006/D1 for support.

In this draft ruling, the ATO makes the comment that it was Parliament’s intent for income to represent "income" as determined under the ITAA and not to be limited to "income" under ordinary concepts.

Business real property and water rights

A number of NTAA members have recently expressed concerns over the ability of an SMSF to purchase a water right from, or lease a water right to, a related party of the fund.

It is also our understanding that several farming representative groups have approached different politicians about this issue and that these representations have gained momentum because this problem is increasingly causing angst amongst a number of farming communities.

By way of background, in certain parts of Australia the ownership of primary production land also entitles the owner to the property to an accompanying water right. In most cases, the owner of the primary production land must also be the owner of the water right.

Therefore, an SMSF that acquires primary production land may be acquiring two assets, namely the title of the underlying primary production land and a water right.

Furthermore, it may also be a commercially prudent decision for an SMSF to acquire the water right with the land (where this is an option) because the value of the land is enhanced where a water right is attached.

However, an SMSF that purchases primary production land and a water right in relation to the property may be breaching the in-house asset rules where the property is leased to a related party.

In these circumstances, an in-house asset problem arises because the SMSF is providing the related party with the use of two assets.

It is providing the related party with the use of the primary production property which is excluded from the in-house asset rules because it represents business real property (refer to S.71(1)(g) of the SIS Act) and it is also providing the use of the water right.

Unfortunately, the definition of business real property that is contained in S.66(5) of the SIS Act does not appear to extend to a water right, and this understanding has been confirmed by the ATO via an Interpretative Decision.

In particular, in ATO Interpretative Decision 2004/229 the ATO concluded that a water right did not constitute business real property for the purposes of S.66(5) of SIS Act.

It reached this conclusion, correctly we believe, on the basis that the ordinary dictionary meaning of "real property" is limited to the "land and interests in land" and it did not (and does not) extend to a water allocation or entitlement that is authorised by a water licence.

The above interpretation is likely to create substantial problems for many SMSFs that currently own primary production land and lease it to a related party. These funds may be inadvertently breaching the in-house asset rules where the fund also owns water rights which attach to the property.

The NTAA requests that the ATO determines whether a water right represents business real property for the purposes of S.66 (i.e., acquiring assets from a related party) and S.71 (i.e., the in-house asset rules).

If not, we request that the SIS Act be amended to broaden the definition of "business real property" to include water rights/allocations associated with primary production land.

Another way to achieve the desired outcome mentioned above involves amending the SIS regulations to provide a specific exclusion for water rights from the definition of an in-house asset.

Such an amendment to the SIS regulations would ultimately provide relief from the in-house asset rules being sought by virtue of the operation of S.71(1)(j)(i) and (ii) of the SIS Act.

ATO Response

The ATO confirmed that a water right did not represent "business real property" and thus represents an in-house asset where the water right is used by a related party to a superannuation fund.

However, the ATO appeared agreeable to amendments being made to eliminate this problem. They acknowledged that the rules were not designed to create an in-house asset problem where an SMSF allows a related party to use a water right that attaches to the land.

Equally, the ATO also appreciated the sensitivity of the issue and they have given a commitment to work with us and issue a determination under S.71 of SIS Act to overcome this problem.

Self managed superannuation funds carrying on business

The NTAA is concerned that a number of ATO publications have almost "out of hand" taken the view that an SMSF would breach the sole purpose where it carries on a business.

By way of illustration, at page 6 of the ATO publication "DIY Super - It’s your money….But not yet" the following comment is made regarding SMSFs carrying on a business:

"…Our view is that if a superannuation fund is running a business it is not being administered for the sole purpose of providing benefits for members and beneficiaries".

Similar remarks have also been made by the ATO in other publications such as "Self managed superannuation funds - Roles and responsibilities of trustees" and "Self managed superannuation funds - Roles and responsibilities of approved auditors".

The NTAA is concerned that these remarks almost dismiss the acceptance of an SMSF being legally capable of carrying on any type of business. However, at paragraph 13 of Taxation Ruling TR 93/17, the ATO makes the following comments about superannuation funds carrying on a business:

"… Therefore, superannuation funds are generally prohibited from undertaking speculative activities or carrying on an active business such as operating a retail shop, motel or primary production business. However, the activities of a superannuation fund in holding shares and other investments and from time to time realising them may, in some cases, amount to the carrying on of a business (cf. FC of T v Radnor Pty Ltd 91 ATC 4689; (1991) 22 ATR 344)."

That is, TR 93/17 implies that an SMSF may satisfy the sole purpose test in relation to certain activities that may be regarded as amounting to a business. It would appear that the types of businesses being contemplated by the above paragraph would include share trading and funds that turn over their property portfolios so regularly that their activities would be regarded as carrying on a business.

Furthermore, this issue has become particularly important because recent court decisions have shown an increasing willingness of the courts and AAT to treat a taxpayer’s activities as amounting to carrying on a business.

In particular, we believe the decision handed down in Shields v DFC of T 99 ATC 2037 will result in many superannuation funds being considered share traders (i.e., carrying on the business of share trading) where they have large share portfolios which are sold regularly.

Another area in which the strict approach mentioned has also caused confusion relates to superannuation funds investing in tax effective investments.

More specifically, the NTAA has been asked by members whether a superannuation fund satisfies the sole purposes test where it invests in a "tax effective" investment that has a product ruling in which the Commissioner accepts that investors are carrying on a business for the purpose of various tax concessions.

The NTAA therefore seeks clarification on whether a superannuation fund can carry on any type of business activity and satisfy the sole purpose test. If so, we would ask that current and future ATO publications and guidelines be amended to accept that superannuation funds can carry on certain business activities (e.g., share trading).

ATO Response

The ATO accepted that there are certain "businesses" that an SMSF can conduct without breaching the sole purpose test under S.62 of the SIS Act.

More specifically, the ATO accepted that an SMSF which carries on either of the following businesses is unlikely to fail the sole purpose test:

• share trading as a result of a large share portfolio and turnover that is regarded as commensurate with being a share trader; and
• a primary production, afforestation or other agriculture style business by virtue of investing in a tax effective investment, whereby the fund is not actively involved in the business and represents a passive investor (e.g., as is the case with most tax effective investments).

The ATO also agreed to update a number of its current publications to reflect a more flexible approach in relation to this issue.

However, the ATO made it abundantly clear that SMSFs are generally only entitled to conduct a limited number of businesses. Some examples that were submitted during the meeting which received no ATO support included property development, actively conducting a primary production business and viticulture.

Individual and corporate trustees

Editor: A superannuation fund is a complying fund where it meets the requirements of S.19 of the SIS Act.

One of the main requirements contained in S.19 of the SIS Act relates to the trusteeship of a regulated fund. In particular, S.19(3) of the SIS Act provides that a regulated fund must have a constitutional corporation as trustee unless the governing rules of the fund provide that the sole and primary purpose of the fund is the provision of old age pensions.

The NTAA seeks clarification on whether an SMSF with an individual trustee can make lump sum payments to members or beneficiaries of the fund, without the need for the members or beneficiaries to commence receiving a pension from the fund and then commute the amount into a lump sum payment.

The NTAA is concerned that certain correspondence has been released by the ATO which insinuates that a fund with an individual trustee cannot immediately pay out a lump sum amount to a member or beneficiary of the fund once a condition of release has been satisfied.

The indication from the ATO’s correspondence was that the chronology of events must involve the fund initially paying out a pension and the member or beneficiary then commuting the amount into a lump sum.

ATO Response

The ATO acknowledged that an SMSF with an individual trustee can pay out a lump sum benefit to member(s) of the fund without breaching the requirements contained in S.19 of the SIS Act.

In fact, the ATO gave a clear undertaking that they will take the same approach to this issue as the previous Regulator (being APRA).

That is, an SMSF can make a lump sum payment to a member or beneficiary of the fund where there is an individual trustee without the need to initially commence paying a pension. Reference should also be made to Superannuation Circular III.A.1.

Unpaid present entitlements to SMSFs

The NTAA has also received feedback indicating that the ATO is intending to treat an unpaid present entitlement between a unit trust and a superannuation fund (as a unitholder of the unit trust) as a loan to the unit trust for the purposes of the in-house asset rules that are contained in S.71 of the SIS Act.

Typically, the above situation will arise where a unit trust (of which a superannuation fund is a unitholder) makes the unitholder presently entitled to income of the trust without physically paying the distribution.

In most cases, the unpaid entitlement to the superannuation fund (i.e., as a unitholder) is not recorded in the unit trust as a loan and it is treated as an amount that is held "on trust" for the benefit of the superannuation fund.

The above treatment has been predicated on the ATO’s interpretation of unpaid entitlements in relation to the deemed dividend rules that are contained in Div.7A of the ITAA 1936.

That is, the ATO has publicly stated that an unpaid entitlement between a trust and a company (as a beneficiary or unitholder of the trust) is not regarded as a loan for Div.7A purposes.

The ATO has accepted that the unpaid entitlement represents an amount that is held on trust for the benefit of the company and, therefore, the deemed dividend rules do not apply to these arrangements because there is no "loan" being provided by the company.

Therefore, the NTAA seeks clarification from the ATO on whether an unpaid entitlement between a unit trust and a superannuation fund will be treated as a "loan" for the purposes of the in-house asset rules.

ATO Response

The ATO accepted that an unpaid present entitlement does not of itself create a loan for superannuation purposes.

However, the Tax Office did say that it will consider whether an unpaid trust distribution from a trust is to be treated as a reinvestment in the trust for the purposes of the in-house asset rules.

Editor: Ah well . . . it's never easy. One step forward, one step back. We'll get back to you.