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In this newsletter we include the fourth and final article in the SMSFs and Property series where we look at recent Australian Taxation Office (ATO) guidance on property development within an SMSF.
There has been a considerable increase in property development activity by self-managed super funds over the last few years, prompting the ATO (the regulator of SMSFs) to take a closer look.
As a result, the ATO has released regulatory guidance to the trustees of SMSFs setting out their concerns and providing guidance in two key areas:
- Diverting property development profits into a self-managed super fund: Taxpayer Alert 2023/2 released 15 June 2023
- Compliance concerns and the potential risks of property development activity through an SMSF: SMSFRB 2020/1 released 13 March 2020.
Where property development activities are carried out in accordance with both the superannuation and taxation rules, they should not create either a compliance or tax concern for the SMSF.
In fact, the ATO has clearly stated in the past that this is a legitimate investment for SMSFs and that they have no concerns with SMSFs investing in property development so long as the development complies with the super and tax rules.
The key issue is that all activities must be within the strict compliance regime that all SMSF trustees need to work within.
We will cover these compliance requirements shortly, but first we need to look at the more recent issue that focuses on the diversion of property development profits into an SMSF.
Concerns around profit diversion
In mid-June 2023, the ATO released a taxpayer alert outlining their concerns around property development activity being carried out within an SMSF where the intention is to divert the profits from that development into the superannuation system.
The ATO’s concerns stem from the fact that the tax rate applicable to these activities is considerably lower within the superannuation environment than it would be if these activities were carried out through more traditional entities like companies.
Complying super funds pay a maximum rate of tax of 15%, whereas profits from a company are usually taxed at 30%. After-tax profits can then be paid to the shareholders of that company who receive a credit for the 30% tax which has already been paid:
- If the shareholders own tax rate is less than 30%, they receive a refund of tax already paid
- Where the shareholders own tax rate is higher than 30%, they pay an additional amount of tax to reflect this.
If the shareholders of that entity include a complying SMSF that pays a maximum 15% tax, you begin to see how a tax benefit can arise.
Consider a more standard arrangement where a property development would be carried out through a company with profits paid out to the individual shareholders. The individuals would usually have a marginal tax rate considerably higher than the 15% tax rate of a super fund.
This is one of the issues sparking ATO concerns about property development carried out through an entity that has been set up solely for the purpose of that development and where the shareholders include tax concessional entities like SMSFs.
Taxpayer alert 2023/2
Issues raised in this taxpayer alert cover situations that include:
- Where there is an intention to shift profits from property development activities from a related entity to an SMSF where the profits are concessionally taxed
- Where the SMSF has either a direct or indirect ownership in a “special purpose vehicle” (SPV) which is established for the purpose of carrying out the development
- Where that SPV then engages with other related parties that are controlled by the SMSF members (or their associates) to complete the development activities
- Where these services are not carried out on arm’s-length terms
- Where the above results in an increase to the profits generated from the property development and those profits are shifted into the lower tax environment of super.
If these issues are present within the arrangements entered into by an SMSF, the ATO has said it will look to apply the general anti-avoidance (Tax) rules which will result in additional tax and penalties being imposed on the SMSF.
This can also result in all income from the development, including capital gains, being taxed at the top marginal rate (45% excluding Medicare) instead of the 15% concessional tax rate applicable to complying super funds.
It is also interesting to note the following comments made by the ATO regarding this issue:
- That the ATO is looking to impose penalties on professionals who are promoting these arrangements to their clients.
- If you have any concerns around activities that you have entered into within your own SMSF, you are encouraged to contact the ATO by way of making a voluntary disclosure or seek a private binding ruling.
In addition to the issues relating to tax and profit diversion are the usual superannuation laws and compliance requirements that SMSF trustees must adhere to.
Many of these issues were covered by the ATO in SMSFRB 2020/1, their regulatory bulletin on SMSF and property development.
The main issues covered in the bulletin includes the following:
Related party involvement
Where the entity carrying out the development is a related party or part 8 associate of the SMSF, it is absolutely necessary for all interactions between these parties to be entered into and then maintained on an arm’s-length basis.
Both parties need to ensure they deal with each other the same as they would if they were unrelated, so neither party to the transaction is treated any more favourably.
It is also important that evidence is obtained and retained to prove that this has in fact occurred.
Where the terms of the arrangement are not at arm’s length, or where there is insufficient evidence to prove this, it can result in either a superannuation compliance issue, a tax issue or both.
- Where the terms of the arrangement are more beneficial to the other (non-SMSF party) then there would be a breach of the SIS arm’s-length rules (Section 109). This will often lead to a contravention that needs to be reported by the fund’s auditor.
- Where the terms of the arrangement are more beneficial to the SMSF, it would create a non-arm’s length income issue under the tax rules, resulting in all SMSF income (and capital gains) from the development being taxed at the top marginal tax rate.
Sole purpose test
Any SMSF involvement in a development must be for the sole purpose of providing fund members with retirement benefits.
There can be no form of current day benefit given to members by including the SMSF in the project, so this will require a clear reasoning as to why the SMSF is involved in the development and what the trustees expect to achieve when it is complete.
Where a related party is involved in the development, it is important that the SMSF trustees act only in the best interests of the fund members.
SMSF trust deed rules
It is important that activities and investments entered into or carried out by the fund’s trustees are in accordance with the fund’s trust deed.
It is essential that you refer to your trust deed before considering any form of fund activity or investment. You should be looking for clear guidance around these activities and that they are not prohibited or restricted by the rules set out in the trust deed.
SMSF investment strategy
Consideration must be given to the fund’s existing investment strategy and what it allows. In many cases, trustees will need to update the fund’s strategy documentation prior to any investment taking place.
Trustees should consider clearly defining why the SMSF is involved in the property development. The outcomes likely to be achieved should also be contained within the fund’s investment strategy.
Of course, where there are related parties involved in the development then this becomes even more relevant.
SMSF trustees considering a property development within their fund need to have a clear understanding of the relevant rules and restrictions they must adhere to.
Where advice has been provided around the use of an interposed entity to carry out the development, it may be worth discussing this with your relevant advisor and, if you think it’s appropriate, seek a second opinion.
Be sure to obtain and retain clear and concise evidence on all activities and transactions that take place, particularly where those transactions involve a related party.