Recent clarification by the Australian Taxation Office has been welcomed by SMSFs wanting to run a business. Bryce Figot explains.
An ongoing question for SMSF trustees has been whether or not they are able to run a business within a super fund. Few SMSF trustees have been aggressive enough to run a retail shop. However, many have wanted to engage in real estate development that might constitute a business.
The Australian Taxation Office (ATO) have recently provided a very positive clarification.
BACKGROUND – WHY EVERYONE HAD A FUNNY FEELING
The starting point is the case of Scott v Commissioner of Taxation (No 2), a 1966 High Court decision. Here, Leslie Scott, in addition to practising as a lawyer, had large interests in land, both in buying and selling and in letting to tenants for rent. He also engaged in these real estate activities through private companies. Scott arranged for a superannuation fund to be formed. The fund members were Scott, his wife and his parents-in-law. Over five years, the fund received approximately £5,500 of contributions yet its assets grew to £59,869.
‘Coupled with this, there have been many cautionary comments from the ATO over the years’
The judgment does not detail the exact extent of the trustee’s activities. But it is made clear that the massive growth in fund assets was “not made by investing in the ordinary way” and was instead mainly due to profits made by dealings in land, involving subdividing and selling the land off in allotments. These dealings were financed through borrowed monies (superannuation funds could borrow in those days). It was accepted that the fund’s activities constituted a business.
The High Court found that the fund had been established merely as a continuation of Scott’s activities outside of the fund. The High Court ultimately concluded that profits made by buying land with borrowed money and selling it were not income of a fund and that the fund was not actually a superannuation fund.
Coupled with this, there have been many cautionary comments from the ATO over the years. These comments never expressly banned SMSF trustees from running a business. For example, from the National Tax Liaison Group Superannuation Sub Committee minutes for a meeting held on 26 October 2005:
“[T]here is nothing in the legislation to prevent it. However, there are potentially a number of issues in carrying on a business that might lead to contraventions of the SIS Act and regulations (such as the sole purpose test), or the borrowing of money. As each case must be considered on its own merits, the Tax Office cannot give a more definitive answer.”
Interestingly, there is a little-known ATO ruling that implicitly accepts that superannuation fund trustees can run businesses. Taxation ruling TR 93/17 considers the income tax deductions available to superannuation funds. It states that “a superannuation fund that carries on such a business may rely on the second limb of section 8-1, which covers expenditure necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income”. Naturally, this ruling is also tempered with comments like, “superannuation funds are generally prohibited from undertaking speculative activities or carrying on an active business such as operating a retail shop, motel or primary production business”.
HIGH COURT DEVELOPMENTS – WORD INVESTMENTS
At the risk of over-simplifying, the 2008 High Court decision of Word Investments Limited v Commissioner of Taxation considered whether a company that ran a business met the charity equivalent of the sole purpose test. The company ran a funeral business charging clients a commercial margin of profit. Profits were then donated to another entity that clearly was a charity. Effectively this raised the question of whether the ends justified the means. Four out of five judges answered in the affirmative, holding that the company’s activities were charitable because they were carried out in furtherance of charitable purpose.
Although not expressly a superannuation case, Word does have implications for superannuation funds. Namely, it lends support for the view that SMSF trustees running a business meet the sole purpose test if the business profits are retained in the fund to pay for things like retirement benefits.
POSITIVE CLARIFICATION FROM ATO
The ATO have released a page on their website titled: “Carrying on a business in a self-managed superannuation fund.” It can be found at: <http://ato.gov.au/print.asp?doc=/content/00241937.htm>.
It makes the following points:
Firstly, when determining compliance with the SIS provisions, it is the activities of the trustee that are examined rather than whether a business is being carried on by the SMSF trustee. A strict standard of compliance is required under the sole purpose test. If an SMSF trustee carries on a business, the ATO will examine the activities closely to ensure that the sole purpose test is not breached.
Again, Word lends support to the view that the ends can justify the means. So provided the activities are profitable and profits are being retained in the fund, the sole purpose test should be met.
Secondly, the ATO have said they will scrutinise situations such as:
• Where the SMSF trustee employs a family member. The ATO will look at things like the stated rationale for employing the family member and the level of salary or wages paid. Naturally, this is a more flexible position than the blanket ban on employing anyone whatsoever that many conservative advisers have been implemented for their SMSF clients.
• Where the business carried on by the SMSF trustee has links to associated trading entities. This can be a concern because many builders often want to develop real estate through their SMSFs. That being said, this is not a blanket ban but merely a flag that the ATO will scrutinise. Naturally, such SMSF trustees must be very careful not to acquire assets from related parties, et cetera.
• Where there are indications that SMSF assets are available for the private use of related parties.
Finally, the ATO remind us of all of the key regulatory provisions, including:
• The need for an investment strategy that has regard to all the circumstances of the SMSF.
• The prohibition on lending money or providing any other financial assistance to SMSF members or their relatives. Although being employed is arguably financial assistance, the earlier ATO comments suggest that it can be allowable provided that the level of wages paid is reasonable and justified.
• The prohibition on SMSF trustees acquiring assets from related parties of the SMSF. The ATO has expressed their view on this topic in more detail in self-managed superannuation fund ruling SMSFR 2010/1. Broadly, if an SMSF trustee contracts with a related party entitling the SMSF to the performance of a service by the related party, then where performance of service is the substance of the transaction, the acquisition of the performance of a service is allowable, even if small assets are also acquired (for example, tap washers). However, acquiring the big-ticket items (for example, ducted air-conditioning) would not be allowable. It is important that these items are purchased directly by the SMSF trustees and merely installed by the related party.
The website guidance is positive. However, as always, common sense should still prevail. SMSF trustees wanting to generate funds for retirement et cetera in a way that might constitute a business must be particularly mindful to comply at all times with all regulatory provisions.
Bryce Figot is a senior associate at leading SMSF law firm DBA Lawyers Pty Ltd – www.dbalawyers.com.au Bryce can be contacted at bfigot@dbalawyers.com.au