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Self Managed Super Fund (SMSF) Article
Twisting arms on superannuation tax
By Tony Negline.
This article may be out of date.
19th November 2008
When some super funds are working out how much tax to pay each year on their income they have to work out a Low-tax Income Component and Non-arm's Length Income Component.
Non-arm's Length Income Component is taxed at the highest marginal rate – that is, 46.5%. If this penalty tax rate applies it will affect relevant realised capital gains and income supporting pensions.
The Low-tax Income Component for complying super funds is taxed at 0% for assets supporting current pension liabilities and 15% for other assets.
Non-arm's Length Income Component is a new term and has applied since July 2008. Under the old tax rules it used to be called Special Income.
A super will have an Non-arm's Length Income Component if it earns income 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 tax measure can apply to any income a fund earns but in order to work out if a fund has Non-Arm's Length Income Component all the following points need to be considered for certain types of income. For example:
- 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, equity holders in a company 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 Although this ruling discusses laws which have been superseded, the ruling has not been withdrawn and makes the following comments which remain highly relevant:
- 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
- "Dividends are only derived on an arm’s length basis when the shares are acquired, the investment is maintained, and the dividends are paid on an arm’s length basis. 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 matters … consider[ed] relevant … [then] it would be reasonable not to treat the dividend as" [Non-arm's Length Component Income]
- Other relevant matters that may be considered in relation to company shares and dividends include firstly the extent to which members who are at arm’s length to the private company have an interest in the superannuation fund, secondly the relationship between the superannuation fund and the private company and 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. The members personally own the premises used to operate their business.
For our purposes assume the asset is a commercial property. They decide the '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 neat idea is to produce a loss when the super fund members sell the property and to maximise the rent payable to the super fund – the investors want a big capital loss for their business and maximise income in their low tax super fund environment.
The objectives of the transaction will ultimately 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. This might take place when benefits have to be paid or when the super fund trustees have to work out how much pension income to pay.
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 cause super and tax law grief.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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