1 From Issue 52, of Superannuation Quarterly, dated March 2011 In a nutshell... Tax deductions for SMSFs This article looks at various tax deductions that are available to a complying Self Managed Superannuation Fund (SMSF) and then explains the general principles governing the deductibility of that expenditure. The article also briefly examines certain non-deductible items of expenditure typically incurred by SMSFs. The taxable income of a complying SMSF is determined as if the trustee were a taxpayer and a resident for tax purposes (s295-10). As a general rule, the deductibility of expenditure incurred by an SMSF is determined under s8-1 of the Income Tax Assessment Act 1997 (ITAA97), unless a specific provision applies (eg. tax compliance costs under s25-5). A deduction is available only to the extent to which the relevant expenditure is incurred in gaining or producing assessable income of the SMSF (see TR 97/7 for the Commissioner s views on the meaning of incurred )....the full article follows All information provided in this publication is of a general nature only and is not personal financial or investment advice. It does not take into account your particular objectives and circumstances. No person should act on the basis of this information without first obtaining and following the advice of a suitably qualified professional advisor. To the fullest extent permitted by law, no person involved in producing, distributing or providing the information in this publication (including Taxpayers Australia Incorporated, each of its directors, councillors, employees and contractors and the editors or authors of the information) will be liable in any way for any loss or damage suffered by any person through the use of or access to this information. The Copyright is owned exclusively by Taxpayers Australia Inc (ABN ). NOTICE FORBIDDING UNAUTHORISED REPRODUCTION No item in this publication covered by copyright may be reproduced or copied in any form (graphic, electronic or mechanical, or recorded on film or magnetic media) or placed in any computer or information transmission or retrieval system unless permission in writing is obtained from Taxpayers Australia Inc. call or download an application form from
2 Superannuation quarterly March Issue Tax deductions for SMSFs By Graeme Evans This article looks at various tax deductions that are available to a complying Self Managed Superannuation Fund (SMSF) and then explains the general principles governing the deductibility of that expenditure. The article also briefly examines certain non-deductible items of expenditure typically incurred by SMSFs. The taxable income of a complying SMSF is determined as if the trustee were a taxpayer and a resident for tax purposes (s295-10). As a general rule, the deductibility of expenditure incurred by an SMSF is determined under s8-1 of the Income Tax Assessment Act 1997 (ITAA97), unless a specific provision applies (eg. tax compliance costs under s25-5). A deduction is available only to the extent to which the relevant expenditure is incurred in gaining or producing assessable income of the SMSF (see TR 97/7 for the Commissioner s views on the meaning of incurred ). PRUDENTIAL WARNING Tax deductibility implications aside, SMSFs should always pay careful consideration to the sole purpose test and other provisions of the Superannuation Industry (Supervision) Act 1993 (SISA93) and its supporting regulations before incurring any expenditure. Payments made by third parties The treatment of SMSF expenses paid by third parties on behalf of an SMSF is set out in Taxation Ruling TR 2010/1 (see para 172). Where a person pays an amount to a third party (eg. an Independent SMSF Auditor) on behalf of an SMSF, the payment is treated for all tax purposes as though the person had made an in-specie contribution to the SMSF and the fund has separately paid an equal amount to the third party. (Note: TR 2010/1 replaces MT 2005/1.) [Unless otherwise stated, all legislative and regulatory references are to the ITAA97.] PART A Allowable deductions (non-exhaustive) General deductions In the absence of a specific provision, expenditure of an SMSF which is not of a capital, private or domestic nature, is deductible under s8-1 to the extent that: it has the essential character of an outgoing incurred in gaining or producing assessable income, or it has the character of an operating or working expense of a business or is an essential part of the cost of the fund s business operations. As a SMSF would be in breach of the sole purpose test if it ran a business, the second element to s8-1 is not relevant to SMSFs. The general principles governing the deductibility of expenditure incurred by all superannuation funds is contained in Taxation Ruling TR 93/17. List of general deductions Subject to the possible need for apportionment (see TR 93/17 and below), the expenses of an SMSF which are ordinarily deductible under s8-1 include: administration fees (see TR 93/17) actuarial costs (see TR 93/17) accountancy fees (see TR 93/17) audit fees (see IT 2625 & TR 93/17) trustee fees and premiums under an indemnity insurance policy (see TR 93/17) legal fees (eg. costs of amending a trust deed in order to satisfy regulatory requirements or increase day to day operational efficiency) except where of a capital nature (see IT 2672 & TR 93/17) costs in connection with the calculation and payment of benefits to members (but not the cost of the benefit itself), such as interest on money borrowed to secure temporary finance for the payment of benefits, medical costs in assessing invalidity benefit claims etc (see TR 93/17) investment advisor fees and costs in providing pre-retirement services to members membership subscriptions paid to professional associations costs of collecting or receipting of contributions (even if they are not assessable contributions) (see s295-95(1))
3 subscriptions to share market information services and investment journals to the extent the expense relates to earning dividend or interest income from a portfolio of shares or bonds (see TD 2004/1), and other administrative costs incurred in managing the fund. As the amount of non-arm s length income is reduced by deductions to the extent that they are attributable to that income (s (2)) with the resultant amount being taxed at 45%, it is clearly important to identify those deductions that are attributable to that non-arm s length income. Apportionment General administrative expenses relevant to the operation of a superannuation fund as a whole, and non-capital expenses incurred in producing investment income, must generally be apportioned using the methods specified in Taxation Ruling TR 93/17. Apportionment ensures that the expenditure is deductible only to the extent to which it is incurred in producing assessable income (but see Cost of collecting contributions below). Therefore, apportionment would be necessary in the case of undifferentiated expenditure. See below for a further discussion on the issue of apportionment. Specific discussion on certain allowable deduction under s8-1 Investment-related expenses The exact nature of the investment-related expenses is critical in determining deductibility. For example, commissions and ongoing management fees are ordinarily deductible, but upfront fees incurred in investing money are of a capital nature and not deductible. Examples of deductible investment-related expenses include: ongoing management fees or retainers paid to advisers or costs of servicing and managing an investment portfolio (see IT 39, TD 95/60; ATO ID 2004/139), and the cost of advice to change the mix of investments, whether by the original or a new adviser, provided it does not amount to a new financial plan ( TD 95/60). WARNING If the investment-related advice covers other matters, or relates in part to investments that do not produce assessable income, only a proportion of the fee is deductible (eg. no deduction is available for management fees debited to a retiree s allocated pension account (see ATO ID 2004/968)). Cost of collecting contributions When applying s8-1, contributions made to an SMSF are taken to be included as assessable income, whether or not it is an assessable contribution (s295-95(1)). This means that the SMSF can deduct amounts incurred that are related to the collection or receipt of the contributions, even where they are not assessable contributions (also see TR 93/17). Trust deed amendments Trust deed amendments may be deductible under either s8-1 or s25-5 if: the amendments are necessary due to changes in Government regulations and are made to ensure that the fund s day-to-day operations continue to satisfy the Regulator s requirements (see IT 2672), or the amendments make administration of the fund more efficient and do not result in a restructuring of the fund (see TR 93/17). Specific deductions ATO Supervisory levy The Tax Office s Supervisory levy is set at a flat amount of $150 and is payable annually by all SMSFs. The imposed levy is deductible as a tax-related expense under s25-5. The levy is deductible in the financial year it is paid. The following super specific penalty items are not deductible: late payment penalties (s26-5) late lodgement penalties (s26-90), and the Superannuation Guarantee Charge (SGC) (s26-95). Tax compliance and advice costs A SMSF is eligible to claim a deduction under s25-5 for tax-related expenses to the extent it is for: managing its own tax affairs (eg. fees paid to a registered tax agent for preparing an income tax return, fees paid to a solicitor or registered tax agent for tax planning advice and costs incurred in disputing an assessment)
4 complying with an obligation imposed by a Commonwealth law, insofar as that obligation relates to the tax affairs of an entity (eg. the cost of supplying the Tax Office s information and documents concerning the income tax affairs of another entity), or general interest charge (GIC) and the shortfall interest charge on unpaid tax and penalty and underpayments of tax. However, see Tax compliance and advice costs and Penalty items under PART B - Non-allowable deductions. Deductions for insurance premiums and death or disability benefits A complying SMSF that provides death or disability benefits may claim a deduction for the provision of these benefits (s ). The portion varies depending on the nature and type of policy and uses one of the following methods: premiums paid basis (s ), or actual cost basis (s ). These deduction provisions apply to the following types of benefits: superannuation death benefits disability superannuation benefits, and benefits consisting of an amount payable to a person as an income stream because of the person s temporary inability to perform normal employment duties that is payable during this period of inability up to age 65. WARNING ON TRAUMA POLICIES A deduction is not available under s in respect of premiums paid for trauma policies. These policies fail to meet the definition of a death or disability benefit. This issue was considered in ATO ID 2002/371 under former s279(1) of the Income Tax Assessment Act Please note that if an SMSF receives a rebate or refund of premiums for which a deduction has been allowed under s , the amount of the rebate or refund is included in the SMSF s assessable income for the financial year in which it is received (s item 4). For example, this could occur if a policy is cancelled during a year and the unused portion of premiums is refunded. [Editor: For a complete discussion of death or disability deductions for SMSFs, please refer to an article entitled Death or disability deductions for SMSFs which appeared in Superannuation Quarterly, Issue 50 September 2010 p 1.] New legislation currently before Parliament At the time of writing the Tax Laws Amendment (2010 Measures No. 5) Bill 2010 was before Parliament. This Bill extends the range of benefits in s to include Terminal Medical Condition (TMC) benefits. The benefits in s are benefits in relation to which complying superannuation funds and retirement savings account providers can claim a deduction. If enacted, this measure will have effect from 16 February Deductions for anti-detriment payments A continuously complying super fund (ie. one that has always been subject to concessional tax treatment, or subject to concessional tax treatment since 1 July 1988 if in existence before then), may be entitled to a deduction under the anti-detriment payment provisions in s when the following occurs. The fund pays a superannuation lump sum because of the death of a person to the trustee of the deceased s estate or an individual who was a spouse, former spouse or child of the deceased at the time of death or payment. Since 1 July 2008, same-sex couples and their children are treated the same as opposite-sex couples and their children. The fund increases the lump sum by an amount (the Tax Saving Amount (TSA)) to effectively refund any contributions tax that has been paid on contributions made on behalf of the member. The SMSF needs to pay out the TSA and then claim a tax deduction on its assessable income (as calculated in accordance with s (3)) to recover the amount paid from the Tax Office. The deduction can be claimed in the year of payment and any unused amount is carried forward to future years. The anti-detriment provisions can provide a significant taxation benefit to continuing members of the fund by reducing tax payable in future years. The ability for the trustee to increase death benefit payments and claim the corresponding deduction must be allowed under the trust deed. This is best if it is expressly specified as a power, and not an absolute requirement, in the trust deed. As the SMSF will need to pay out the increased benefit amount before the benefit is recovered from the Tax Office via a tax deduction, the SMSF must ensure that it has available reserves or fund to make the increased payment amount. Payments to deceased estate If the recipient of the superannuation death benefit is the trustee of the deceased member s estate, the deduction allowable only relates to the portion of benefit to which the dependants of the deceased member may
5 reasonably be expected to benefit from the estate (s (4)). Deduction amount The amount that the fund can deduct using the formula in s (3) is calculated as: (Tax saving amount / low tax component rate) where: the low tax component rate is the rate of tax imposed on the low tax component of the fund s taxable income for the income year (ie. 15%), and the tax saving amount is the amount of contributions tax refunded through an increased death benefit payment. If the actual tax saving amount cannot be calculated by the SMSF, the Tax Office will accept an alternative formula. In ATO ID 2007/219, the Commissioner states that he will accept an alternative method, as set out below, as a means of calculating the tax saving amount in s (3) where the actual amount cannot be calculated by the superannuation fund. (0.15 x P)/(R 0.15 x P) x C where: P = the number of days in component R that occur after 30 June 1988 R = the total number of days in the service period as defined in s that occur after 30 June 1983, and C = the taxable component of the lump sum calculated under s , as if no deduction under s (2) were allowed, after excluding the actual (if any) insured amount for which deductions have been claimed under s or s The superannuation fund in ATO ID 2007/219 is a fully taxed accumulation fund, where the member s benefits are the sum of contributions and investment income earned on those contributions over the period of membership, less expenses such as fees, taxes and insurance premiums. Members may transfer superannuation benefits into the fund from other funds. The details of the benefits transferred from other superannuation funds do not include the actual effect of tax paid by that fund. Therefore, the fund cannot calculate the amount of tax paid on amounts in the member s accounts as its records do not track the effect of fund tax on individual accounts over the membership period. Example Shane commenced his SMSF on 1 October He died on 1 October The value of his account to be paid as a death benefit to his wife is $220,000 and is all taxable component. Shane was born on 20 January 1950 and would ordinarily have retired on 20 January His SMSF fund has been a complying superannuation fund since commencement. His account balance included some roll-over benefits so the SMSF was not able to calculate the tax savings amount. The tax saving amount is calculated as: (0.15 x P)/(R 0.15 x P) x C where: P = days from 1 October 1991 to 1 October 2009 = 6,575 days R = days from 1 October 1991 to 1 October 2009 = 6,575 days C = $220,000 The tax saving amount is: (0.15 6,575) (6,575 (0.15 6,575)) $220,000 = $38,824 The amount of the deduction allowed to the SMSF under s is $38,824/15% = $258,827. Provided the fund pays a benefit of $258,824 (being $220,000 + $38,824) to Shane s wife, the fund will be allowed a deduction of $258,827. This deduction can be used to offset tax liability in the current year. Any unused deduction can be carried forward to offset tax liability in future years. The alternative method under ATO ID 2007/219 is desirable especially where the deceased member s account may include benefits transferred from other super funds, and those benefits do not include the actual effect of tax paid by that fund. In ATO ID 2008/111, the Commissioner states that when calculating the TSA, the superannuation fund can also take into account the interest that would have been earned on the contributions if tax had not been imposed. WARNING If an SMSF trustee increases a superannuation lump sum benefit to take advantage of the deduction under s , the amount of the increase is a concessional contribution where it is allocated to the deceased member s account from a reserve (unless the exclusion in r (4)(a) of the Income Tax Assessment Regulations (ITAR97) applies. If the amount is not allocated to the member s account from a reserve, it will not be a concessional contribution unless it is funded from a contribution that meets the requirements of s292-25(2).
6 Clawback amount deduction A complying SMSF s assessable income in a year of income may be reduced by a clawback amount in respect of assessable contributions of an earlier year of income (s (1) item 2). This arises where a member s contributions have been included in the fund s assessable contributions in a year of income and, after the lodgement of the fund s income tax return, the trustees receive a s notice from the member which reduces the amount of the contributions to be included in assessable contributions. Such a notice must be received by the end of the financial year after the year in which the contributions were made. In such a case, the clawback amount is allowed as a deduction from the fund s assessable income in the year that the notice is received. If the fund is unable to fully utilise the clawback amount deduction (eg. the fund s taxable income in that year is exceeded by the deduction or the fund would lose the benefit of franking credits), the fund has the option of amending its assessment of the fund for the year in which the contributions were included in assessable income (s (2) and (3)). Example Cliff is a member of an SMSF. On 10 August 2009 he lodged a notification with the fund trustee stating his intention to claim a tax deduction for the full $10,000 he contributed to the fund during the financial year. The SMSF lodged its tax return in November 2009 and included the $10,000 as assessable income. When Cliff s personal tax return was completed by his accountant in March 2009 he decided to reduce the amount of the deduction to only $6,000 and notified his fund accordingly. Unless the SMSF decides to first exercise the option under s (3), it is able to claim a tax deduction for the $4,000 contributions (ie. the clawback amount) in its tax return under s (1) item 2. Assessable contributions that are also fringe benefit amounts A complying SMSF can deduct for the income year in which contributions are received, those contributions included in the fund s assessable income that are fringe benefits, as these will be taxed as fringe benefits in the hands of the contributor (s item 1). Expenses relating to investments in PSTs and life policies A complying SMSF may claim a deduction for expenses incurred in relation to investments in Pooled Superannuation Trusts (PSTs) or in life insurance policies issued by life companies or in custodian trusts under such policies (s & TD 1999/6). Any profit, gain or bonus derived from investments in PSTs and life policies is treated as assessable income for the purposes of applying the deduction provisions. Investment or administration charges levied by a PST or life office which are generally of a capital nature are not deductible, unless they are not of a capital nature. However, except where deductible under s (see Deductions for insurance premiums and death or disability benefits above) a complying superannuation fund is not entitled to a deduction for fees or charges incurred in respect of: complying superannuation/first Home Saver Account life insurance policies or exempt life insurance policies, or units in a PST that are segregated current pension assets of the fund (ie. exempt units in the PST). Apportionment General administrative expenses relevant to the operation of a SMSF as a whole, and non-capital expenses incurred in producing investment income, must generally be apportioned using the methods specified in TR 93/17. Apportionment ensures that expenditure is deductible only to the extent to which it is incurred in producing assessable income. Apportionment of certain expenses may be necessary where: the expense is partly capital in nature, or the expense relates to income which is partly assessable, partly exempt or partly non-assessable and non-exempt. Even where a SMSF has exempt current pension income (ECPI), certain specific deductions can be claimed in full, such as the supervisory levy and death or disability premiums. For further information on ECPI, please refer to an article entitled Exempt Current Pension Income which appeared in Superannuation Quarterly, Issue 51, March 2011, p 6. The appropriate method of apportionment is a question of fact. Taxation Ruling TR 93/17 contains two methods of apportioning expenditure which are acceptable to the Commissioner. An SMSF may, however, use any other method that produces a fair and reasonable assessment. SMSFs cannot claim deductions for approved auditor fees, management and administration expenses where all or part of the item relates to ECPI.
7 If all the income derived by an SMSF is claimed as ECPI, and there is no other assessable income, these tax-related expenses should not be shown in section C deductions under label J or label L or any other label in the Self-managed superannuation fund annual return (NAT 71226). No deductions are allowable against exempt income. The two methods of apportioning expenditure suggested in TR 93/17 are noted below. 1. Method 1 Non-capital expenditure incurred in gaining or producing investment income only (eg. investment manager fees) can be apportioned according to the formula: (Expenditure (Assessable investment income / Total investment income)) 2. Method 2 General administrative expenses relevant to the operation of the fund as a whole can be apportioned according to the formula: (General administrative expenses (Assessable income / Total income)) where total income means assessable income plus exempt income, and assessable income for apportionment purposes includes all contributions to the fund (whether assessable contributions or not), net capital gains, imputation credits and foreign income gross ups. PART B Non-allowable deductions (non-exhaustive) Deed establishment and amendment costs Capital expenditure incurred in establishing the structure for a regulated superannuation fund (eg. purchase of a trust deed) is not deductible (see s40-880(1), ATO IDs 2003/524 and 2003/525). Typical expenditure that would be of a capital nature and be non-deductible would include amendments made relating to the cost of establishing a trust, executing a new deed for an existing fund or amending a deed to enlarge or significantly alter the scope of the trust s activities. However see Allowable deductions where such costs may be deductible where they are incurred to amend a trust deed to satisfy operational compliance (IT 2672) or to make the administration of the fund more efficient (see TR 93/17). Business capital costs Section s allows deductions over a five-year period for expenses incurred by taxpayers to establish business structures, such as a company or trust (commonly called blackhole expenditure ). The capital expenses of setting up a complying SMSF (eg. establishing a corporate trustee and other formation expenses) do not qualify for the s deduction as the fund is not carrying on a business in the usual sense, even though it is producing assessable income predominantly from its investments and taxable contributions. Tax compliance and advice costs Certain tax-related expenditure is expressly not deductible as specified in s25-5. The use of the words to the extent in s25-5(1) indicates that, where appropriate, the expenditure has to be apportioned between deductible and non-deductible items of tax-related expenditure. For example, capital expenditure is not deductible under s25-5(4), although expenditure is not capital expenditure merely because the tax affairs concerned relate to matters of a capital nature. In addition, the use of a capital asset for a tax-related matter is treated as an income-producing use for the purposes of the section except where another provision of the ITAA97 or the ITAA36 specifically provides otherwise (s25-5(5), (6)). This means that expenditure incurred in purchasing capital items for use in connection with a tax-related matter is not deductible under s25-5(1), such as a computer to assist the taxpayer in completing a tax return (although s25-5(5) operates to allow depreciation). Upfront investment-related expenses Upfront fees incurred in investing money are of a capital nature and not deductible (see TD 95/60 and ATO ID 2004/968). Instead, the up-front fees may form part of the cost base for determining a capital gains tax liability. In addition, seminar-type expenses may 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. Legal expenses The deductibility of legal expenses usually depends on whether the expenses are of a capital or revenue nature (see IT 2672). Penalty items The following super specific penalty items are not deductible: late payment penalties (s26-5) late lodgement penalties (s26-90), and the Super Guarantee Charge (SGC) (s26-95).
8 Payment of benefits Benefits paid by complying SMSFs are not deductible (s item 1). The term benefits is intended to cover any payments, whether lump sum, pension or annuities to a member, the estate or dependants of a deceased member, made by reason of the member s membership of the fund. Trauma policy premiums A premiums basis deduction is not available under s in respect of premiums paid by a SMSF for trauma policies, as trauma policies fail to meet the definition of a death or disability benefit. This issue was considered in ATO ID 2002/371 under the former s279(1) of the ITAA36. Conclusion The issues surrounding tax deductions can be complicated for SMSFs. Where appropriate, we recommend that the services of a Registered Tax Agent be sought. Members of Taxpayers Australia can also utilise our member helpline service on For Superannuation Australia members, particularly SMSF trustees and their advisers dealing with issues associated with tax deductions, this helpline is available for a purchase price of $55 per query or a block of five for $220.