I hope you are having a great October; and to think Christmas is only nine weeks away! As we are coming towards the end of the year, this month’s newsletter focuses on a few main issues which you may be effected by:

1) Scrutiny by the ATO on self-managed super funds which have most of their assets in property. 2) Changes to Division 7A loans from 1 st July 2020.

The investment strategies of Self-Managed Superannuation Funds (SMSFs) are under scrutiny with the Australian Taxation Office (ATO) contacting 17,700 trustees about a lack of asset diversity.

The ATO is concerned that, “a lack of diversification or concentration risk, can expose the SMSF and its members to unnecessary risk if a significant investment fails.”

This does not mean that you must have diversity in your fund. A lack of diversity might be a strategic decision by the trustees but you need to be able to prove that the strategy was an active decision. Section 4.09 of the Superannuation Industry (Supervision) Regulations require that trustees “formulate, review regularly and give effect to an investment strategy that has regard to the whole of the circumstances of the entity.” To do that you need to:

• - Recognise the risk involved in the investment, its objectives and the cash flow of the fund
• - Review the diversity of the investment strategy (or otherwise) and the exposure of a lack of diversity
• - Assess the liquidity of the investment and cash flow requirements of the fund
• - Assess the ability of the fund to discharge its liabilities, and
• - Review and have in place appropriate insurance cover for members and assets

Importantly, you need to be able to justify how you formulated your strategy if the ATO asks.

The 17,700 people being contacted by the ATO hold 90% or more of the fund’s assets in a single asset or single asset class.

Property is one of the problem areas the ATO is looking at. With property prices at a low point, the asset value of many funds has diminished.

In addition, debt taken on by SMSFs has significantly increased. The number of SMSFs using Limited Recourse Borrowing Arrangements (LRBAs) to purchase property has increased significantly from 13,929 (or 2.9% of all SMSFs) in 2013, to 42,102 (or 8.9% of all SMSFs) in 2017. For SMSFs that have purchased property through an LRBAs, on average, these LRBAs represent 68% of total assets of the funds.

LRBAs are most common in SMSFs with a net fund size (total assets excluding the value of the amount borrowed) of between $200,000 and $500,000. In 2017, the average borrowing under a LRBA was $380,000 and the average value of assets was $768,600.

If you need any help or financial advice, our team would be happy to assist. So if you need help do not hesitate to contact me.

Changes to Division 7A loans

The government has announced the number of changes to the Division 7A loans from 1 st July 2020.

Changes to Division 7A of the Income Tax Assessment Act 1936 proposed by the Australian Treasury will make it both more difficult and more expensive for individuals to access private company funds by way of a loan for personal use, but could also penalise businesses wanting to reinvest profits using intergroup loans, CPA Australia has told a Treasury consultation.

Division 7A was introduced to stop company owners and their associates avoid tax by taking funds out of a company for personal use, for example by making a loan to themselves. Without Division 7A, the funds lent may have been be subject to company tax, but business owners could arbitrage the lower company tax rate to avoid paying the full 47 per cent top personal income tax rate.

However, the law is extremely complex and in 2014 the Board of Taxation recommended changes that would discourage misuse while still enabling business-to-business loans for working capital purposes.

In late 2018, Treasury released a consultation paper that goes further, by arguing essentially for all loans to be treated on a similar footing regardless of purpose.

This has raised concerns that by discouraging all related-party loans, business investment will be hampered.

Unintended costs for business

CPA Australia supports the intent of tightening the rules for individual loans but has concerns about the proposed changes.

“Given what is proposed in the consultation paper, it seems an important point has been missed. The rules need to be modified to be fit for purpose, to achieve their policy objective, but not to stymie business investment,” says Paul Drum FCPA, CPA Australia general manager external affairs.

Drum would like to see business-to-business loans for working capital purposes not captured by Division 7A.

“As long the funds are used for working capital purposes, they shouldn’t be forced into Division 7A interest and principal repayments amongst related entities,” he says. “But, if the funds are being used for private use and enjoyment, then absolutely there should be loan arrangements in place because that would seem on the face of it potentially side-stepping the tax system.”

In its submission to the Treasury consultation, CPA Australia says a proposed 10-year loan model, alleged to be "more closely aligned to commercial practice for principal-and-interest loans" may have a negative impact on small business cash flow "and at the very time our engagement with the sector indicates that access to finance is becoming more difficult".

Members have also raised points of clarification and concerns about a proposal to bring unpaid present entitlements into Division 7A, particularly for those arising prior to December 2009.

A risk of double taxation

At issue are proposed changes to the rules governing intergroup loans, which could result in double taxation under some of the proposals contained in the Treasury paper.

In some businesses, particularly in the construction sector, trusts are formed for specific projects or developments. The project is then funded by way of a loan to the trust from a finance company within the group.

Under the Board of Taxation recommendations, a trust would have a three-year interest-only period before it has to start repaying the loan. This is an important provision for property development projects that often do not have cash flows for several years until after completion and sale.

However, under the proposed new laws, the trust would have to start repaying the loan immediately, paying back at least 10 per cent of the principal plus interest annually. Without cash flows, in order to repay the loan, the trust would have to receive a dividend payment from the financing entity, which would then be used to repay the loan.

Companies will be paying franked dividends, where the owners will have to pay top-up tax on the dividends and as a result will be repaying the business-to-business loan using after-tax dollars. This would essentially result in a tax rate to the business group of 47 per cent rather than the current small business tax rate of 27.5 per cent.

Furthermore, Treasury proposes increasing the interest rate for intergroup loans from 5.2 per cent to 8.3 per cent, increasing the overall cost of the business project and its ability to generate a profit.

Changes could stall economic activity

In its recommendations, the Board of Taxation advocates less stringent requirements for intergroup loans used for business purposes and argues that such loans will not result in a cost to revenue (as interest income is offset by deductions claims), and therefore will not reduce the ultimate amount of tax payable by the corporate group.

If you have any concerns regarding how the proposed changes my effect you, please do not hesitate to contact me at [email protected] or on 1300 365 125 to discuss further.

Please Note: Many of the comments in this publication are general in nature and anyone intending to apply the information to practical circumstances should seek professional advice to independently verify their interpretation and the information’s applicability to their particular circumstances.