Tag Archives: NALI

Perils travelling to your SMSF’s overseas residential property investment

across the border - icon created by Three musketeers - Flaticon

Will a self managed superannuation fund (SMSF) investment in an overseas apartment or investment property open up assisted overseas travel opportunities for the members of the SMSF? Can or should the SMSF reimburse the members who travel to an overseas residential property (ORP) to improve, maintain or to get the ORP ready for letting, for their travel costs? Are the travel expenses deductible to the SMSF or to SMSF members who incur them?

Deductions

These expenses are not deductible to a SMSF member as they are not incurred in earning assessable income of a SMSF member. Rental income earned by a SMSF is not income of a SMSF member. It follows only the SMSF earning the rental income is placed to deduct its expenditure on earning its assessable income under section 8-1 of the Income Tax Assessment Act (ITAA) 1997 (see the Kei example given by the Australian Taxation Office (ATO) at Rental properties and travel expenses | Australian Taxation Office https://is.gd/mucEvN ) while the SMSF is in accumulation phase.

Limits on travel expenses to income earning residential properties

Since 2017 travel expense deductions, that might have been deductible under section 8-1 before then, have been restricted by section 26-31 of the ITAA 1997 which provides:

Travel related to use of residential premises as residential accommodation
(1) You cannot deduct under this Act a loss or outgoing you incur, insofar as it is related to travel, if:
(a) it is incurred in gaining or producing your assessable income from the use of residential premises as residential accommodation; and
(b) it is not necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income.
Exception–kind of entity
(2) Subsection (1) does not stop you deducting a loss or outgoing if, at any time during the income year in which the loss or outgoing is incurred, you are:
(a) a corporate tax entity; or
(b) a superannuation plan that is not a self managed superannuation fund; or
(c) a managed investment trust; or
(d) a public unit trust (within the meaning of section 102P of the ITAA 1936); or
(e) a unit trust or partnership, if each member of the trust or partnership is covered by a paragraph of this subsection at that time during the income year.

section 26-31 of the ITAA 1997

SMSFs earning residential rents are more likely to be, and be treated as, investors and not business operators and in those cases the SMSF won’t carry on a business that satisfies the negative limb of paragraph 26-31(1)(b) meaning travel expense deductions will indeed be constrained by section 26-31.

and see:
Rental properties and travel expenses | Australian Taxation Office https://is.gd/mucEvN

How about the SMSF earning residential rental income through a business?

Generally SMSFs are poorly placed to carry on a business of earning rents from its residential properties:

  1. for regulatory reasons: see: Carrying on a business in an SMSF | Australian Taxation Office https://is.gd/ildkCR; and
  2. for structural reasons including scale and other reasons considered in:
    1. Taxation Determination TD 2011/21 Income tax: does it follow merely from the fact that an investment has been made by a trustee that any gain or loss from the investment will be on capital account for tax purposes?;
    2. Commissioner of Taxation v. Radnor [1991] FCA 499; and
    3. section 295-85 of the ITAA 1997 under which capital gains tax, as it applies to investors, is specified as the primary income tax code applicable to complying superannuation funds (CSFs).

How about the SMSF earning income from use of the ORP as an airbnb or similar?

Under the goods and services tax rules residential premises, rents from which are input taxed, are distinguished from commercial residential premises such as motels and the like where tariffs are for taxable supplies of accommodation. But even if the ORP of a SMSF is commercial residential premises for GST purposes this does not mean they are not residential premises for the purposes of section 26-31.

The A New Tax System (Goods And Services Tax) Act 1999 provides:

Residential rent

 (1) A supply of premises that is by way of lease, hire or licence (including a renewal or extension of a lease, hire or licence) is input taxed if:

  (a) the supply is of residential premises (other than a supply of commercial residential premises  or a supply of accommodation in  commercial residential premises provided to an individual by the entity that owns or controls the  commercial residential premises ); or

  (b) the supply is of commercial accommodation and Division 87 (which is about long-term accommodation in commercial premises) would apply to the supply but …

sub-section 40-35(1) of the A New Tax System (Goods And Services Tax) Act 1999

which shows that, even for GST purposes, commercial residential premises is not a carve out from residential premises as such but the GST legislation differentiates only for specific purposes, viz. those in section 40-35, where supplies of residential premises that are not commercial residential premises are input taxed.

So an ORP used as an airbnb or similar can still be residential premises for the purposes of paragraph 26-31(1)(b) even though they may be commercial residential premises to which paragraph 40-35(1)(a) of the A New Tax System (Goods And Services Tax) Act 1999 may apply.

Can the SMSF meet the travel expenses in any case even when they are non-deductible for income tax?

A trustee of a SMSF may consider:

  • paying the cost of the flight directly; or
  • reimbursing the director/s but on a non-deductible basis.

But these concerns with the SMSF meeting the travel costs also need to be considered:

  • the expense may not be incurred on an arm’s length basis as required under section 109 of the Superannuation Industry (Supervision) [SIS] Act 1993;
  • the expense and other circumstances of the investment in ORP may indicate that the investment in ORP is not being maintained for the purposes listed under section 62 of the SIS Act; or
  • the expense may be a non arm’s length expense (NALE) viz. a loss, outgoing or expenditure caught by the non arm’s length income (NALI) rules in section 295-550 of the ITAA 1997 applicable to complying superannuation entities including SMSFs either in accumulation phase or pension phase.

Following the Treasury Laws Amendment (Support for Small Business and Charities and Other Measures) Act 2024 a NALE is taxed to the SMSF at the highest marginal rate based on twice the difference between the NALE incurred and what would have been incurred had the SMSF met the NALE on an arm’s length rate: see new sub-section 295-550(8) of the SIS Act. The first two infractions  viz. the arm’s length requirement in section 109 and the sole purpose test in section 62, have potentially wider and more serious ramifications.

Actions the ATO can take against trustees of SMSFs

Section 62 should only apply where a SMSF acquires and holds ORP seemingly as a lifestyle choice, that is for the use or enjoyment of members rather than to provide for the retirement, permanent incapacity or for dependents on death of members being the sole purposes for which regulated superannuation funds can invest.

SMSF funded travel expenses so a member, family and friends can travel to an ORP to stay can stand out to the ATO as the use of the ORP as lifestyle asset diverging from permissible purposes.

As the regulator of SMSFs, the ATO can:

  • apply to an Australian superior court to impose civil penalties on the trustee/s or its director/s of the SMSF (SMSFTsDs): section 197 of the SIS Act 1993 for breach of  a civil penalty provision: section 193, further bearing in mind that an Australian superior court can impose criminal sanctions on SMSFTsDs where the court finds a breach of a civil penalty provision involve dishonesty for financial gain, deception or fraud: section 202 of the SIS Act 1993; and/or
  • determine that a SMSF is a non-complying fund due to contravention of a civil penalty provision: paragraph 39(1)(b) and section 42 of the SIS Act 1993.

Should the ATO go to court then fines for breach of a civil penalty provision can easily be around $20,000 per breach and other orders, such as education orders, can be made, and the trustees/ directors can be disqualified from acting as SMSFTsDs.

Meeting travel expense in a SMSF – rethink

So, given all this can occur, hard questions should be asked before a SMSF meets travel costs of member or related party of a SMSF to visit an ORP.

  • Could the visit to the ORP for inspection, maintenance or investment evaluation have been done by a locally based professional or tradesperson at arm’s length from the SMSF where no or negligible local travel costs would have been incurred?
  • What did the member do other than these activities on the overseas journey to the ORP?
  • What tariff did the member pay where the member or their related parties where accommodated at the ORP?
  • Why was an ORP, which is more challenging to inspect and maintain from a distance, chosen as a preferred investment in line with the investment strategy of the SMSF?

Non-compliance – loss of nearly half a SMSF’s assets in income tax

Where a SMSF is made non-complying by the ATO then item 2 of table in section 295-320 of the ITAA 1997 applies which broadly brings the assets in the SMSF as a non-CSF that was previously a CSF to income tax at, presently, a 45% rate. From then on, while the SMSF remains a non-CSF, that rate applies to income of the SMSF.

The range of outcomes that can happen where SMSFTsDs breach the SIS Act 1993, including the 45% tax on all assets, is considered in this video from the ATO: SMSF – What happens if your fund breaches the law? – ATOtv https://is.gd/YQSRJE .

Disproportionate consequences

So there is risk of significant and disproportionate consequences where travel costs are subject to ATO review or audit. It is up to the trustee of the SMSF as to how this risk is best dealt with.

It follows that if there is payment for or reimbursement to the directors it should be scrupulous – backed by strong reason as to the imperative for a member to attend an ORP in person with costs carefully apportioned where there is any private component with no tax deduction claimable by the SMSF unless section 26-31 of the ITAA 1997 can somehow be addressed.

Icon created by Three musketeers – Flaticon

Income from private company investments – the tax scourge of SMSFs

increase

A self managed superannuation fund (SMSF) is generally a low tax entity, particularly when in pension phase where a nil rate can apply and a low 15% rate can apply when not. Still the taxable income of a complying superannuation fund (SF) can be split into a non-arm’s length component and a low tax component under section 295-545 of the Income Tax Assessment Act (ITAA) 1997. The non-arm’s length component is taxed at the highest individual marginal rate which is 45% in the 2019-20 income year.

Non-arm’s length income

The non-arm’s length component for an income year is the complying SF’s “non-arm’s length income” (NALI) for that year less any deductions to the extent that they are attributable to that income.

NALI picked up on audit – even higher tax

The recent case in GYBW v. Commissioner of Taxation [2019] AATA 4262 (GYBW) is a cogent reminder of how NALI taxed at the highest marginal rate can arise in a SMSF. In GYBW a tax shortfall arose as the NALI not returned by the SMSF was detected in an audit by the Commissioner of Taxation. Hence even higher taxes applied including shortfall interest and penalties. There was a reduction in penalties on appeal to the AAT from “reckless” to “failure to take reasonable care” level.

NALI

Section 295-550 is one of a number of superannuation rules designed to protect the integrity of the low tax complying SF regime by combatting income shifting arrangements where income, that might be taxed elsewhere to another type of taxpayer at higher rates, is non-commercially shifted to a complying SF that attracts a low rate of tax.

Section 295-550 is directed at non-arm’s length dealings where complying SFs (and other superannuation entities) earn income from an arrangement which exceeds the income that the complying SF might have been expected to derive from the arrangement if the parties to the arrangement had been dealing with each other at arm’s length.

Where section 295-550 is enlivened all of the income from the arrangement is NALI taxed at the highest rate.

Private companies dividends prone to be NALI

At the forefront of NALI is dividend income from investment by complying SFs in private companies.

In GYBW Senior Member McCabe identified an objective test in sub-section 295-550(2) which looks at a question of fact: is a dividend paid by a private company to a complying SF consistent with an arm’s length dealing? A private company dividend paid to a SMSF is NALI to the SMSF if it is not. This objective test replaced the former provisions in Part IX of the ITAA 1936 under which private company dividends were treated as special income (the forerunner to NALI) as a matter of course. That is, unless the Commissioner exercised a discretion that it was unreasonable to treat the private company dividend as special income where the Commissioner became satisfied that the income was earned at arm’s length.

Sub-section 295-550(3) sets out factors to be considered in applying the objective test.

The facts and findings in GYBW

In GYBW, the SMSF was the SMSF of a partner in an accounting practice with the pseudonym D. His client and connection pseudonym K had volatile and valuable business interests which could earn significant income from Department of Defence contracts.

D retired from his accounting practice to become the chief financial officer of the B Group.

The various partnership and corporate dealings of K are complex and supporting evidence of them before the AAT was “difficult” and incomplete. The AAT did not accept:

  • that the evidence, though involving non-related parties D, K, K’s trust and the other partners and former partners of K; and
  • that legal advice received before the SMSF invested in B Holdings;

supported a finding that the shares in pseudonym B Holdings acquired by D’s SMSF were acquired on terms where dividends would be earned from the shares consistently with an arm’s length dealing.

Senior Member McCabe observed how parties at arm’s length from each other can engage in an non-arm’s length dealing just as non-arm’s length parties can engage in an arm’s length dealing. For instance, in the latter case, a family member of the seller acquiring stock exchange listed shares of the seller on a stock exchange. Section 295-550 is directed to the dealing viz. how the SMSF came to earn the private company dividends it earned, not to the relationship of the parties to the arrangement. The AAT was therefore sceptical about the acquisition by D’s SMSF of ordinary shares in B Holdings on its formation for a nominal sum where B Holdings was also able to obtain and exploit K’s business interests a day later which D contended had negligible value then.

That AAT observed that “Fortune shined on the business” of B Holdings and B Holdings earned more than $10 million over four years which likely explains why it was picked up for an audit by the Commissioner.

Darrelen applicable

After looking at the Explanatory Memorandum with which section 295-550 was introduced Senior Member McCabe concluded that the purpose of the section did not change nor was there any change to the factors to which regard was to be had. Therefore the Full Federal Court decision in Darrelen Pty Ltd v Federal Commissioner of Taxation (2010) 183 FCR 237, which concerned the former provisions in Part IX of the ITAA 1936, remained authoritative in Senior Member McCabe’s view. In Darrelen the court had held that dividends paid by a private company were special income. In the case the SMSF had acquired its four shares in that company for a cost far less than their market value in an earlier year of income notwithstanding that the same dividend amount was paid on all 100 shares in the income year it was paid.

The cost to the SMSF of the shares on which the dividend was paid

The cost to the SMSF of the shares on which dividends were paid is a specific factor that can be taken into account under paragraph 295-550(3)(b) in determining whether their payment is consistent with an arm’s length dealing. In applying the objective test Senior Member McCabe referred to Commissioner of Succession Duties (SA) v Executor Trustee and Agency Co of South Australia Ltd (Clifford’s Case) where the High Court set out its views on how to value shares in a company:

The main items to be taken into account in estimating the value of shares are the earning power of the company and the value of the capital assets in which the shareholder’s money is invested. But a prudent purchaser does not buy shares in a company which is a going concern with a view to winding it up, so that the more important item is the determination of the probable profit which the company may be reasonably expected to make in the future, because dividends can only be paid out of profits and a prudent purchaser would be interested mainly in the future dividends which he could reasonably expect to receive on his investment. Further, a prudent purchaser would reasonably expect to receive dividends which would be commensurate with the risk, so that the more speculative the class of business in which the company is engaged the greater the rate of dividend he would reasonably require. In order to estimate the probable future profits of a company it is necessary to examine its past history, particularly the accounts of those years which are most likely to afford a guide for this purpose. In order to estimate the rate of dividend that a prudent purchaser could reasonably require on his investment it is necessary to examine the nature of the business and the risks involved and to seek the evidence of business men, particularly members of the stock exchange and experienced accountants, who can testify to the appropriate rate from the prices paid for shares in companies carrying on a similar business listed on the stock exchange or from private sales of shares in such companies or from their general business experience.

[1947] HCA 10; (1947) 74 CLR 358 at p.362

and with the benefit of hindsight, and omissions in the evidence supporting D’s SMSF’s case about how the SMSF and B Holdings came to benefit in K’s business interests, the AAT found that dividends were not consistent with arm’s length dealing as they arose from shares acquired for less than their value so evaluated. The AAT found that the dividends received by D’s SMSF from B Holdings were NALI.

NALI rules extended to expenses

The NALI rules have extended to losses, outgoing or expenditures that are less than expected to the complying SF by the Treasury Laws Amendment (2018 Superannuation Measures No. 1) Act 2019 in Schedule 2.

Conclusion

Unless GYBW is overturned on appeal SMSF investment in a private company of a related party or in a private company of the connections of the SMSF seem destined for NALI high tax treatment. So SMSFs should be wary of investment in private companies generally: SMSF investment in a private company carries the suspicion that the investment is an opportunity to shift income from a higher taxed entity to a concessionally taxed SMSF.

It follows that the trustee of a SMSF looking to sustain concessional tax treatment needs to adequately document its dealings with and investment in private companies so the arm’s length character of the investment can be verified and, where need be, independent valuation supporting consistency with arm’s length dealing should be sought.