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Self Managed Super Fund (SMSF) Article
Beware of super income traps
By Tony Negline.
This article may be out of date.
23rd February 2010
A super fund will earn non-arm's length income if it comes from investments or arrangements where two parties are not dealing with each other at arm's length and the super fund earned more income than might have been expected had the two parties been operating at arm' length.
This non-arm's length income sources might be taxed at the highest marginal tax rate, that is, 46.5% and this penalty tax rate will apply to all relevant capital gains and income including those supporting pensions.
The tax law calls this income Non-arm's Length Income Component.
All other income and capital gains of a complying super fund is called Low-tax Income Component and is taxed at 0% for assets supporting current pension liabilities and 15% for other assets.
Between 1988 and 2007, Non-arm's Length Income Component used to be called Special Income.
In order to work out if a super fund has Non-Arm's Length Income Component the following points need to be considered:
1. Company shareholdings
- the value of shares in the company that the super fund owns, and
- the cost to the super fund of the shares on which the dividend was paid, and
- the rate of that dividend, and
- whether the company has paid a dividend on other shares in the company and, if so, the rate of that dividend, and
- whether the company has issued any shares to the super fund in satisfaction of a dividend paid by the company (or part of it) and, if so, the circumstances of the issue, and
- any other relevant matters
All of these issues must be considered in conjunction with each other.
2. Any non-fixed entitlement of a trusts – income will automatically be deemed to be Non-arm's Length Income Component
3. Fixed entitlements to a trust where the entitlements aren't determined on an arm's-length basis
The Non-arm's Length Income Component rules can also apply to non-share equity interests and non-share dividends.
In August 2006 the Tax Office released a tax ruling about the old "Special Income" rules. Although this ruling discusses laws which have been superseded, the ruling has not been withdrawn and makes the following highly relevant comments:
- Non-arm's Length Component Income can include, if applicable, interest on loans, rent from property, and profit on sale of assets capital gains and franking credits
- "If the shares are acquired at market value, the private company is not involved in non-arm’s length dealings and the rate of dividend is the same as the rate of dividend paid on other shares in the company or is reasonable having regard to investment risk" and there are no other relevant matters then it wouldn't be reasonable to treat those dividends as Non-arm's Length Component Income
Last year the ATO won a case involving this old law before the Administrative Appeals Tribunal. However the AAT told the ATO that it didn't agree that shares have to be acquired at market value. I understand the taxpayer has appealed some aspects of this case to the Federal Court. We're unlikely to hear how the Tax Office will react to this AAT comment until this litigation is finalized.
- Other relevant matters that may be considered in relation to company shares and dividends include firstly the extent to which fund members who are at arm’s length to a private company have an interest in the superannuation fund, secondly the relationship between the superannuation fund and the private company, thirdly the relationship between the superannuation fund and any party with which the private company has dealings and finally who the superannuation fund acquires the shares from and the circumstances of that acquisition.
To explain how the Non-arm's Length Income Component income provisions might work, let's look at an example.
The members of a small fund have come up with a bright idea. They personally own the premises used to operate their business.
For our purposes assume the asset is a commercial property. They decide to 'sell' the property to their super fund for $1. The super fund's trustees have agreed that they will lease this property to the business for 200% more than a market based rent.
The purpose of this apparently neat idea is to produce a loss when the asset is sold to the super fund and to maximise the rent payable to the super fund.
The objectives of the transaction will fail. When the super fund acquires the asset, it will pay stamp duty on the market value of the asset. Also at some point the super fund will have to value the asset at a net market value. The previous owner will have to pay Capital Gains Tax and other taxes based on the net market value. The excessive rental is likely to be classed as Non-arm's Length Income Component.
If the previous owners decide that the transfer of the asset should be classed as an in-specie contribution then the tax laws demand that the contribution be valued at a net market value.
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