A recent decision Re Trustee for the Payne Superannuation Fund and FCT  AATA 58 examines how the ATO are examining whether SMSFs are appropriately carrying forward tax losses and apportioning expenses when they are partly in pension mode. Prior to analysing the implications of this decision, we will first examine a general overview of how the tax rules in relation to losses in an SMSF environment operate.
SMSFs, like other taxpayers, may accumulate revenue losses that can offset future assessable income. (We distinguish here between revenue and capital losses as we do not deal with capital losses here in any detail.)
What is a revenue tax loss?
Broadly, a revenue loss is one that is not a capital loss. For example, a revenue loss may arise where an SMSF has borrowed to investment in a rental property and the SMSF is negatively geared, ie, its expenses (particularly interest on a limited recourse borrowing arrangement aka LRBA) exceed the rental and other income that the SMSF derives.
How does this differ to a capital loss?
Broadly, a capital loss is one that relates to where a CGT event occurs and the cost base (or reduced cost base, as applicable) is greater than the consideration received.
Generally, a capital loss can only offset a capital gain. However, where an SMSF is in pension mode and has adopted the segregated method, then any capital loss is disregarded; as is any capital gain on disposal of a segregated asset on capital account: s 118-320 of the Income Tax Assessment Act 1997 (Cth) (‘ITAA 1997’).
In contrast, if an SMSF is unsegregated, then any capital loss is carried forward for offset against any future net capital gain in accordance with the method statement in s 102-5 of ITAA 1997.
Are there special rules for an SMSF to carry forward a revenue loss?
An SMSF is a form of trust and trusts must generally satisfy the applicable tests in Schedule 2F of Income Tax Assessment Act 1936 (Cth) (‘ITAA 1936’) to be in a position to carry forward revenue losses. However, an SMSF is an ‘excepted trust’ as an excepted trust in s 272-100(b) includes a complying superannuation fund. A fund is a complying superannuation fund if it satisfies the criteria in s 45 of SISA (see s 272-140 of ITAA 1936). The trust loss measures in Schedule 2F of ITAA 1936 therefore do not apply to a complying SMSF (which is trust that is an excepted trust).
Accordingly, an SMSF that has revenue losses from its own activities will generally not be required to make a family trust election (‘FTE’). In comparison, a discretionary family trust typically has to make an FTE to be able to carry forward a revenue loss. A unit trust that is not a fixed trust will also generally be required to make an election.
Moreover, where an SMSF holds investments in a unit trust, this may invoke the requirement for the SMSF to make a FTE or, in some circumstances, an interposed entity election (‘IEE’). This is required, for instance, where the unit trust is not a fixed trust.
A fixed trust includes unit trusts which do not have any non-fixed or discretionary entitlements, ie, beneficiaries have a vested and indefeasible interest. A ‘fixed trust’ is defined in s 272-65 of ITAA 1936) as follows:
A trust is a fixed trust if persons have fixed entitlements to all of the income and capital of the trust.
The expression ‘fixed entitlement’ in s 272 5(1) of ITAA 1936 is defined to mean:
If, under a trust instrument, a beneficiary has a vested and indefeasible interest in a share of income of the trust that the trust derives from time to time, or of the capital of the trust, the beneficiary has a fixed entitlement to that share of the income or capital.
The concept of fixed entitlements (as defined in s 272 5(1) of ITAA 1936) was considered in Colonial First State Investments Limited v FCT  FCA 16. There, a special resolution (ie, 75%) was able to vary the terms of the trust. Accordingly, it was held that ‘members could vote to terminate the present right to a share of income and capital’ () and thus there were not fixed entitlements as defined in s 272 5(1) of the ITAA 1936.
Unit trust deeds are not a generic product and DBA Lawyers experience is that not many unit trusts from other suppliers satisfy this test of fixed trust. Thus, if an SMSF has invested in a unit trust and that unit trust has revenue losses, then the ability for that unit trust to utilise any current financial year (‘FY’) or carried forward tax losses will, in the first instance, depend on whether it is fixed. In many cases, due to poorly drafted unit trust deeds, the trust will not be fixed.
A fixed trust cannot deduct a revenue loss unless it satisfies the 50% stake test (sub-div 266-40) or the non-fixed trust stake test (s 266-45): s 266-25 of ITAA 1936.
If the particular unit trust in question is not a fixed trust, ie, it is a ‘non-fixed trust’, then the following tests must generally be satisfied for that non-fixed unit trust to carry forward its tax (revenue) losses:
- A continuity of beneficial ownership test (looking at changes in actual and potential beneficiaries): sub-div 269-C of ITAA 1936;
- A pattern of distributions test (looking at consistency in distribution of trust property to beneficiaries prior to the loss year): sub-div 269-D of ITAA 1936;
- A continuity of control test (looking at changes in trustees and appointors): sub-div 269-E of ITAA 1936; and
- An income injection test (looking at the relationship between income sheltered by losses and arrangements entered into or consideration provided by persons which differ from that which would have occurred had the persons been dealing at arm’s length, ie, without the benefit of the trust loss): div 270 of ITAA 1936.
Broadly, it is generally difficult for a non-fixed trust to carry forward its revenue losses unless the appropriate elections are made (eg, an FTE or IEE). Typically if the SMSF holding units in the non-fixed unit trust makes an FTE, the unit trust would make an IEE. There are a number of ATO IDs that relate to this area such as ATO ID 2002/676, 2002/746W, 2002/748W, 2002/749W and 2002/750W. The last four of these ATO IDs have been withdrawn on the basis that they merely restate what the law is but are still of assistance in gaining an understanding of how the law operates.
Is the test for non-arm’s length income different?
It should also be noted that the definition of ‘fixed trust’ for revenue losses in Schedule 2F of ITAA 1936 differs from the ATO’s practice in relation to that term in s 295-550 of ITAA 1997. This practice appeared to be accepted by the ATO in Re MH Ghali Superannuation Fund and FCT  AATA 527 and the paragraphs below, especially at , extracted from TR 2006/7.
Broadly, the paragraphs below provide an insight to the ATO’s practice in relation to NALI which distinguishes between a ‘loose’ fixed entitlement (eg, distributions to unit holders are in proportion to the unit percentages held rather than a strict fixed entitlement as per Sched 2F of ITAA 1936) compared to a discretionary entitlement for NALI (note the ATO accepts that while TR 2006/7 refers to s 273 of ITAA 1936 below, it applies equally to s 295-550 of ITAA 1997):
Trust distributions not arising from a fixed entitlement
- If a complying superannuation fund … derives income from a trust by way of the trustee or any other person exercising a discretion, the income distributed will be special income under s 273(6).
Trust distributions arising from a fixed entitlement
- A trust distribution to a complying superannuation fund … will fall within s 273(7) rather than s 273(6) if the entity’s entitlement to the distribution does not depend upon the exercise of the trustee’s or any other person’s discretion.
- A trust distribution arising from a fixed entitlement will only be special income if three conditions are met:
- the entity must have acquired the fixed entitlement under an arrangement or the income must have been derived under an arrangement;
- some or all of the parties to the arrangement must not have been dealing with each other at arm’s length; and
- the amount of the distribution must be greater than the amount of income that might have been expected if the parties had been dealing with each other at arm’s length.
Careful management of the treatment of revenue losses is therefore required where an SMSF owns units in a unit trust.
As discussed above, where the revenue losses arise directly in the SMSF (ie, there is no investment by the SMSF in to a unit trust), then the SMSF can carry forward its losses as it is an excepted trust under Schedule 2F of ITAA 1936.
Thus, where an SMSF is in accumulation mode, div 36 of the ITAA 1997 sets out how to calculate a loss, how to deduct a loss and how to calculate ‘net exempt income’. The main provisions applicable to an SMSF in div 36 are summarised below. These provisions set out a framework of understanding how losses are treated.
Section 36-10 of ITAA 1997 sets out how to calculate a tax loss for an income year as follows:
- Add up the amounts you can deduct for an income year (except *tax losses for earlier income years).
- Subtract your total assessable income.
- If you *derived *exempt income, also subtract your *net exempt income (worked out under section 36-20).
- Any amount remaining is your tax loss for the income year, which is called a loss year.
How to deduct tax losses
Section 36-15 of ITAA 1997 sets out how to deduct tax losses (of entities other than corporate tax entities).
Your *tax loss for a *loss year is deducted in a later income year as follows if you are not a *corporate tax entity at any time during the later income year.
- If you have no net exempt income
If your total assessable income for the later income year exceeds your total deductions (other than * tax losses), you deduct the tax loss from that excess.
- If you have net exempt income
If you have * net exempt income for the later income year and your total assessable income (if any) for the later income year exceeds your total deductions (except * tax losses), you deduct the tax loss:
- first, from your net exempt income; and
- secondly, from the part of your total assessable income that exceeds those deductions.
However, if you have *net exempt income for the later income year and those deductions exceed your total assessable income, then:
- subtract that excess from your net exempt income; and
- deduct the tax loss from any net exempt income that remains.
- If you have 2 or more *tax losses, you deduct them in the order in which you incurred them.
How to calculate ‘net exempt income
Section 36-20(1) of ITAA 1997 sets out how to calculate ‘net exempt income’. If the taxpayer is an Australian resident, your net exempt income is the amount by which your total *exempt income from all sources exceeds the total of:
- the losses and outgoings (except capital losses and outgoings) you incurred in deriving that exempt income; and
- any taxes payable outside Australia on that exempt income.
SMSF in pension mode with tax losses
When an SMSF derives exempt income (ie, eligible concession pension income or ‘ECPI’) when it is in pension mode, there is a need to manage the fund’s tax position as it may also have revenue losses which the fund can carry forward. This is because, broadly, revenue losses are reduced by exempt income or more specifically by net exempt income.
This requires an SMSF to carefully allocate expenses between both assessable and exempt income prior to ascertaining any carry forward revenue loss. This can easily be overlooked as the ATO have undertaken audit activity on SMSFs not correctly calculating their exempt income and reducing expense claims to the extent that the fund derives exempt income, etc.
In Payne’s case, the SMSF trustee claimed deductions for ECPI. The ATO audited the fund’s tax returns in respect of claims for tax losses and amended assessments were issued apportioning expenses claimed by the fund between the assessable and exempt income resulting in the amount of net exempt income and the carried forward tax losses for FY2010 and FY2011 being adjusted.
The Tribunal in Payne’s decision noted that:
- Under s 36-10 of ITAA 1997, a tax loss can be expressed as the following formula:
Tax loss = [Allowable deductions – Assessable income] – Net exempt income
- A carried forward tax loss is deducted in later income years in accordance with the rules in s 36-15 of ITAA 1997.
- For an Australian resident, the term ‘net exempt income’ is defined in s 36-20. It is used in determining whether a tax loss exists and the manner in which that tax loss is required to be deducted. For a resident taxpayer (such as an SMSF) net exempt income for a FY is the amount by which the total exempt income from all sources for that FY exceeds the total of the losses and outgoings (except capital losses and outgoings) incurred in deriving that exempt income, and any taxes payable outside Australia on that exempt income.
- Specifically, s 36-20(1) is applied to SMSFs in the same way as it is applied to other taxpaying entities, but having regard to provisions of the ITAA 1997 that apply to superannuation funds.
- When s 36-20(1) speaks of losses and outgoings incurred in deriving that exempt income, the section allows a deduction for a loss or outgoing to the extent that it is incurred in deriving that exempt income in that FY.
- There are no provisions of the tax law that provide that where losses and outgoings in relation to exempt income exceed exempt income the excess can be applied to reduce net exempt income in a future FY. Whilst there are specific provisions relating to earlier FY tax losses related to assessable income (eg, ss 36-10 and 36-15 of ITAA 1997) there is no corresponding provision in relation to exempt income.
SMSF to carefully manage their tax losses
The Payne decision is a timely reminder that SMSFs in pension mode need to carefully ensure they do not over claim deductions and ensure expenses are accurately and appropriately allocated between assessable and exempt income. Tax losses must be reduced by net exempt income and any remaining tax loss can be carried forward to a subsequent FY.
Naturally, all else being equal a tax loss may be of little value if the fund derives sufficient net exempt income which will reduce this loss. This may be the case, for instance, after an anti-detriment deduction is claimed and a surviving spouse is left as the sole member of the fund in pension mode. In this instance, the carried forward revenue loss created by the anti-detriment deduction claim will be reduced by the amount of net exempt income (eg, ECPI from pension assets) and the value of these losses eroded year after year. Fortunately, there are a number of planning strategies to ameliorate this type of problem and expert tax advice should be obtained.
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This article is for general information only and should not be relied upon without first seeking advice from an appropriately qualified professional.
Note: DBA Lawyers hold SMSF CPD training at venues all around Australia and online. For more details or to register, visit www.dbanetwork.com.au or call Marie on 03 9092 9400.