Category: Newspaper/Blog Articles/Hansard

Total superannuation balance and limited recourse borrowing arrangements: Part 2

Joseph Cheung (jcheung@dbalawyers.com.au), Lawyer and Daniel Butler (dbutler@dbalawyers.com.au), Director, DBA Lawyers

Under certain circumstances, an individual member’s total superannuation balance (‘TSB’) will be increased by their share of the outstanding balance of a limited recourse borrowing arrangement (‘LRBA’) that commenced on or after 1 July 2018 when the Treasury Laws Amendment (2018 Superannuation Measures No. 1) Bill 2018 (‘Bill’) becomes law.

In Part 1 of our series, we considered how the proposed law applies to members who have satisfied a relevant condition of release with a nil cashing restriction. In Part 2 of our series, we examine how the proposed law applies to members whose superannuation interests are supported by assets that are subject to an LRBA between the superannuation fund and its associate (often referred to as a ‘related party’ in everyday conversation).

For completeness, we note that the proposed law applies to both members of self managed superannuation funds (‘SMSFs’) and other funds with fewer than five members. For the purpose of this article series, we will focus on its application to SMSFs.

Lender is an associate of the superannuation fund

Many advisers and commentators have commented that the effect of the proposed law is that a member’s TSB may be increased if their superannuation interests are supported by an LRBA that involves a ‘related party’ lender. In broad terms, a liability is treated as an asset for a member’s TSB purposes. On a more technical level, the wording in the Bill refers to the term ‘associate’, which is a term defined in the Income Tax Assessment Act 1936 (Cth) (‘ITAA 1936’). In contrast, the term ‘related party’ in the superannuation law context is a term defined in the Superannuation Industry (Supervision) Act 1993 (Cth). The definitions are not identical, although there is significant overlap and similarity. Therefore, to thoroughly consider whether the proposed law has any effect on a member’s TSB, SMSF trustees and advisers need to assess whether the lender or proposed lender is an associate of the SMSF.

We illustrate the effect of the proposed law with an example.

EXAMPLE 1

Edward and Ellen are the only members of their SMSF. The value of Edward’s superannuation interests in the SMSF is $1.2 million. The value of Ellen’s superannuation interests is $800,000. The assets of the SMSF comprise of cash only.

Edward is 52 years old. Ellen is 43 years old.

The SMSF acquires a $3 million property. The SMSF purchases the property using all of its cash (ie, $2 million) and borrows an additional $1 million from E&E Pty Ltd, which is a company controlled by Edward and Ellen. Hence, E&E Pty Ltd is an associate of their SMSF.

The SMSF now holds an asset worth $3 million (being the property). The SMSF also has a liability of $1 million under the LRBA.

Of its own cash that it used, 60% ($1.2 million) was supporting Edward’s superannuation interests and the other 40% ($800,000) was supporting Ellen’s interests. These percentages also reflect the extent to which the asset supports Edward and Ellen’s superannuation interests.

Edward’s TSB is $1.8 million. This is comprised of the 60% share of the net value of the property (being $1.2 million) and the 60% share of the outstanding balance of the LRBA (being $600,000).

Ellen’s TSB is $1.2 million. This is comprised of the 40% share of the net value of the property (being $800,000) and the 40% share of the outstanding balance of the LRBA (being $400,000).

The following are some key points to note from the above example.

  • An increase in the member’s TSB as a result of their share of the outstanding balance of an LRBA can create liquidity issues for the SMSF. Considering the above example, if Edward’s TSB just before 1 July 2019 is $1.8 million (ie, greater than $1.6 million), this would prevent him from making any non-concessional contributions (‘NCCs’) without an excess in the financial year ending 30 June 2020. This may affect the SMSF’s ability to repay the LRBA and fund pension payments and ongoing expenses.
  • An increase in the member’s TSB can also affect other superannuation rights and obligations. (For more information about the various superannuation rights and obligations that depend on a member’s TSB, please refer to the following link: https://www.dbalawyers.com.au/contributions/total-superannuation-balance-milestones/.)

 

Practical application

LRBAs commenced pre-1 July 2018

The proposed law does not apply to:

  • LRBAs that commenced before 1 July 2018; and
  • the refinancing of the outstanding balance of an LRBA that commenced before 1 July 2018.

 

For these circumstances, a member’s TSB is unaffected by the proposed law.

LRBAs commencing on or after 1 July 2018

An SMSF trustee that is considering acquiring an asset via an LRBA should consider the following questions:

1          Is the proposed lender an associate of the SMSF?

2          If so, what is the potential effect of the proposed law on each member’s TSB?

3          Are there are any flow-on consequences, such as the member’s ability to make NCCs, which could affect the SMSF’s ability to repay the LRBA?

Careful planning, analysis and cash flow projections may be necessary before an SMSF trustee can make an informed decision about whether to enter into an LRBA.

 

The above questions also apply for any SMSF that has commenced an LRBA on or after 1 July 2018. If the lender is an associate of the SMSF and the member’s TSB is affected, the SMSF trustee may need to consider whether there are any strategies available to manage the increase in the relevant member’s TSB that results from their share of the outstanding balance of an LRBA.

Some possible strategies relating directly to the LRBA include but are not limited to:

  • Refinancing the outstanding balance of an LRBA to borrow from a lender that is not an associate of the SMSF; or
  • Restructuring the lender (where the lender is not a natural person, eg, a company) so that it is no longer an associate of the SMSF — this is a complex strategy and the SMSF trustee should seek expert advice before making a decision to restructure.

 

Before implementing any strategies, consideration should be given to determine whether the implementation of a certain strategy might trigger the application of the general anti-avoidance provisions such as Part IVA of the ITAA 1936. In this regard, we note that paragraph 4.24 of the Explanatory Memorandum to the Bill states:

…artificially manipulating the allocation of assets that are subject to [LRBAs] against particular superannuation interests at a particular time may be subject to the general anti-avoidance rules in Part IVA of the ITAA 1936 where such allocations formed part of a scheme that had the dominant purpose of obtaining a tax benefit.

 

(For a discussion on some general strategies to manage a member’s TSB, please refer to the following links:

 

Additional tip

It is important to note that even if an LRBA can be refinanced with a lender that is not an associate of the SMSF, the proposed law can still operate to increase a member’s TSB where the LRBA has not been repaid by the time that a member satisfies a relevant condition of release with a nil cashing restriction. Under these circumstances, the member’s share of the outstanding balance of the LRBA will increase their TSB. Accordingly, careful planning and monitoring is required even after an LRBA is refinanced with a lender that is not an associate of the SMSF. For more discussion about this topic, please refer to Part 1 of the article series.

Conclusion

As can be seen from the above, an SMSF trustee that is considering acquiring an asset via an LRBA should consider carefully whether the lender is an associate of the SMSF, and if so, the potential effect of the proposed law on each member’s TSB.

The existing and proposed law in relation to TSB is a complex area of law and where in doubt, expert advice should be obtained. Naturally, for advisers, the Australian financial services licence under the Corporations Act 2001 (Cth) and tax advice obligations under the Tax Agent Services Act 2009 (Cth) need to be appropriately managed to ensure advice is appropriately and legally provided.

DBA Lawyers offers a range of consulting services in relation to TSB and LRBAs. DBA Lawyers also offers a wide range of document services.

Related articles

This article is part of a two-part series and the prior part can be accessed here:

*        *        *

Note: DBA Lawyers hold SMSF CPD training at venues all around. For more details or to register, visit www.dbanetwork.com.au or call 03 9092 9400.

For more information regarding how DBA Lawyers can assist in your SMSF practice, visit

www.dbalawyers.com.au.

28 November 2018

What disqualifies you from having an SMSF?

By Christian Pakpahan (cpakpahan@dbalawyers.com.au), Lawyer and Daniel Butler, Director, DBA Lawyers

This article covers the main ways a person becomes a disqualified person, the consequences of disqualification and the options available to those who are disqualified. (We refer to a trustee in this article as covering both individual trustees of an SMSF and directors of SMSF corporate trustees.)

The ATO will use its powers to render an SMSF trustee a disqualified person where it sees the need, especially for illegal early access breaches. There are other ways a person may become disqualified and some people may not even realise they are disqualified. Acting as an SMSF trustee while disqualified has serious ramifications. It is therefore prudent to be aware of which trustees are or may be disqualified and how a trustee may become disqualified.

Have you ever been convicted of an offence involving dishonest conduct?

The first way a person can be a disqualified person is if they were ever convicted of an offence involving dishonest conduct. This is regardless of whether the conviction was in Australia or a foreign country.

Whether an offence is ‘in respect of dishonest conduct’ is not defined. However, explanatory material to the legislation includes an example of a person convicted of a minor shoplifting offence 20 years ago as an example of an offence involving dishonesty that would disqualify a person. On the other hand, arguably a person convicted of assault is not disqualified, since there is no dishonest intent.

Generally a person who is convicted of an offence involving dishonest conduct is a disqualified person for life. An exception to this rule exists that allows the ATO to waive a person’s disqualified status. Such an application must be made within 14 days of the conviction. Accordingly, a person who anticipates a conviction must act very quickly.

An application outside of this 14 day period may be considered if the ATO is satisfied that there are ‘exceptional circumstances’ that prevented the application from being made within time. Also, a waiver can only apply if the offence did not involve serious dishonest conduct where the penalty is no more than two years’ imprisonment or a fine no greater than a specified amount (eg, 120 penalty units).

Are you a person that is subject to a civil penalty order? 

The second way a person can become disqualified is if a civil penalty order was made against them. Civil penalties are broadly punitive sanctions imposed by the government as restitution for wrongdoing that are imposed through civil procedure rather than criminal process. Civil penalties are typically codified in legislation. Some of the specific civil penalty provisions relating to superannuation are outlined in s 193 of the Superannuation Industry (Supervision) Act 1993 (Cth) (‘SISA’), which include:

Section Description
62(1) sole purpose test
65(1) prohibition on lending to members
67(1) borrowing restrictions
68B(1) promotion of illegal early release schemes
84(1) compliance of in-house asset rules
85(1) prohibition of in-house asset rules avoidance schemes
106(1) duty to notify the Regulator of significant adverse events
109(1) investments of superannuation entity to be made and maintained on arm’s length basis
109(1A) dealing with another party not at arm’s length

In addition to the above SISA provisions, a person may also be disqualified if they are subject to a civil penalty order under other legislation. 

Are you an undischarged bankrupt?

A person who is an undischarged bankrupt is also disqualified, including an undischarged under a foreign bankruptcy law. However, once a person’s bankruptcy period ends, they will cease to be a disqualified person unless they are disqualified for other reasons.

Are you disqualified by ATO action? 

In FY2018 the ATO made 257 SMSF trustees from around 169 SMSFs disqualified. Most disqualifications related to illegal early release of money from SMSFs (around 70% of 169 funds).

Another method open to the ATO is to disqualify because of contraventions of the SISA. The ATO must take into account the nature or seriousness of the contraventions or the number of contraventions. This includes:

  • the behaviour of the person in relation to the contravention;
  • the extent to which a fund’s assets were impacted by the contravention;
  • the extent to which the fund’s assets were exposed to financial risk;
  • the number and extent of contraventions over a period of time;
  • the nature of the contravention in the overall scheme of legislation; and
  • any future compliance risk.

The ATO can also disqualify if it is satisfied that a person is not a ‘fit and proper person’ to be a trustee. In regard to the fitness of a person, the ATO considers whether the person has the relevant skills to be an SMSF trustee having regard to, among other things, the person’s competency and the responsibilities of an SMSF trustee as well as their ability to answer questions put by the ATO.

In regard to whether someone is a proper person to be an SMSF trustee, the ATO considers the person’s general behaviour, conduct, reputation and character. Factors that the ATO will consider in assessing this include, among other things, willingness to comply, proper independence in carrying out the role, whether they have been sanctioned by a professional or regulatory body, management of personal debts, integrity and involvement in entities which have been wound up. Naturally, a person who has outstanding tax debts with the ATO or who has been involved with phoenix company activity would not look good.

Disqualification under this limb can result in adverse public exposure. A person’s disqualified status can easily be obtained from a web search. This adverse public exposure can have a serious adverse impact on a person’s reputation, profession or business. We have had to assist numerous professional and business people who would have suffered considerable loss of business if they were disqualified.

Consequences of being a disqualified person

If a disqualified person knows they are disqualified and continues to act as an SMSF trustee, they will be committing an offence with substantial criminal and civil penalties. Furthermore, it is also an offence for a disqualified person to be an SMSF trustee and not tell the ATO immediately in writing. A disqualified person must also immediately cease being a trustee. Company directors also have an obligation to notify ASIC.

On its website the ATO says that:

if you resign as a trustee your SMSF effectively has six months to restructure itself. Generally this will mean rolling your super interest out of the fund.

Broadly, once an SMSF trustee ceases to act the SMSF has a maximum six month period to comply with the trustee-member rules before it ceases to be an SMSF. An SMSF member is required to be a trustee or a director of a corporate trustee to satisfy the definition of an SMSF. Once disqualified, the person can no longer be an SMSF trustee. The law also prevents the member’s legal personal representative (eg, a person appointed under an enduring power of attorney) from being a trustee in place of a disqualified person. So this may force the person to cease being a member of the SMSF unless another option is chosen.

Options to a disqualified person remaining in an SMSF

Where a person is disqualified the two main options are to roll over the disqualified person’s member benefits to a large (APRA) superannuation fund (eg, an industry or public offer fund) or convert the SMSF into a small APRA fund by appointing an APRA approved trustee.

If the disqualified person has retired or attained 65 or satisfied another condition of release with a nil cashing restriction, they can also consider withdrawing all of their benefits from the SMSF. Corrective action must occur within six months of the trustee’s disqualification.

Conclusion

The matter of disqualification should be monitored well before establishing an SMSF and continually monitored during its life. Advisers should include, for instance, a regular query to clients whether they have been disqualified for any of the above reasons. Clients are not always forthcoming about offences or other indiscretions they may have been guilty of over the years.

*        *        *

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. For more details or to register, visit www.dbanetwork.com.au or call 03 9092 9400.

For more information regarding how DBA Lawyers can assist in your SMSF practice, visit

www.dbalawyers.com.au.

9 November 2018

Total superannuation balance and limited recourse borrowing arrangements: Part 1

Joseph Cheung (jcheung@dbalawyers.com.au), Lawyer and Bryce Figot (bfigot@dbalawyers.com.au), Special Counsel, DBA Lawyers

If the Treasury Laws Amendment (2018 Superannuation Measures No. 1) Bill 2018 (‘Bill’) becomes law, an individual member’s total superannuation balance (‘TSB’) may be increased by their share of the outstanding balance of a limited recourse borrowing arrangement (‘LRBA’) that commenced on or after 1 July 2018. However, the increase only applies to members:

1          who have satisfied a relevant condition of release with a nil cashing restriction, or

2          whose superannuation interests are supported by assets that are subject to an LRBA between the superannuation fund and its associate (often referred to as a ‘related party’ in everyday conversation).

This article (the first in a two-part series) examines the effect of the proposed law on members who have satisfied a relevant condition of release with a nil cashing restriction. For completeness, we note that the proposed law applies to both members of self managed superannuation funds (‘SMSFs’) and other funds with fewer than five members. For the purpose of this article series, we will focus on its application to SMSFs.

Members satisfying a condition of release with nil cashing restrictions

Under the proposed law, the relevant conditions of release with nil cashing restrictions are:

  • retirement;
  • terminal medical condition;
  • permanent incapacity; and
  • attaining age 65.

 

Only members who satisfy the relevant condition of release with nil cashing restrictions will have their TSB increased. We illustrate this with an example.

EXAMPLE 1

Pierre and Samantha are the only members of their SMSF. The value of Pierre’s superannuation interests in the SMSF is $1 million. The value of Samantha’s superannuation interests is $500,000. The assets of the SMSF comprise of cash only.

Pierre is 61 years old and has retired. Samantha is 54 years old and employed on a full-time basis. For completeness, she wishes to continue working until she attains age 65 years. Therefore, Pierre is the only one who has satisfied a condition of release with a nil cashing restriction.

The SMSF acquires a $2.7 million property. The SMSF purchases the property using all of its cash (ie, $1.5 million) and borrows an additional $1.2 million from an unrelated third party lender using an LRBA.

The SMSF now holds an asset worth $2.7 million (being the property). The SMSF also has a liability of $1.2 million under the LRBA.

Of its own cash that it used, two-thirds ($1 million) was supporting Pierre’s superannuation interests and the other one-third ($500,000) was supporting Samantha’s interests. These proportions also reflect the extent to which the asset supports Pierre and Samantha’s superannuation interests.

Pierre’s TSB is $1.8 million. This is comprised of the two-thirds share of the net value of the property (being $1 million) and the two-thirds share of the outstanding balance of the LRBA (being $800,000).

Samantha’s TSB is $500,000. This is because she has not satisfied a condition of release with a nil cashing restriction. Accordingly, the one-third share of the outstanding balance of the LRBA (being $400,000) does not increase her TSB.

The following are some key points to note from the above example.

  • An increase in the member’s TSB as a result of their share of the outstanding balance of an LRBA can create liquidity issues for the SMSF. Considering the above example, if Pierre’s TSB just before 1 July 2019 is $1.8 million (ie, greater than $1.6 million), this would prevent him from making any non-concessional contributions (‘NCCs’) without an excess in the financial year ending 30 June 2020. This may affect the SMSF’s ability to repay the LRBA.
  • An increase in the member’s TSB can also affect other superannuation rights and obligations. (For more information about the various superannuation rights and obligations that depend on a member’s TSB, please refer to the following link: https://www.dbalawyers.com.au/contributions/total-superannuation-balance-milestones/.)
  • Where the loan has not been repaid by the time that a member satisfies a relevant condition of release with nil cashing restriction, the member’s share of the outstanding balance of the LRBA will increase their TSB. Considering the above example, although the one-third share of the outstanding balance of the LRBA does not increase Samantha’s TSB, if she subsequently satisfies a relevant condition of release with nil cashing restriction (eg, retirement or attaining age 65 years) before the LRBA is repaid, her share of the outstanding balance of the LRBA will increase her TSB.

 

Practical application

LRBAs commenced pre-1 July 2018

The proposed law does not apply to:

  • LRBAs that commenced before 1 July 2018; and
  • the refinancing of the outstanding balance of an LRBA that commenced before 1 July 2018.

 

For these circumstances, a member’s TSB is unaffected by the proposed law.

LRBAs commencing on or after 1 July 2018

An SMSF trustee that is considering acquiring an asset via an LRBA should consider the potential effect of the proposed law on each member’s TSB where the members satisfy or are about to satisfy a relevant condition of release with a nil cashing restriction. For example, if a member is about to satisfy a condition of release with a nil cashing restriction because they have met preservation age and are about to enter into retirement for superannuation law purposes, the SMSF trustee may need to consider how the member’s TSB will be calculated if the proposed law comes into operation and upon the member entering into retirement for superannuation law purposes. The SMSF trustee may also consider whether there are any flow-on consequences, such as the member’s ability to make NCCs, which could affect the SMSF’s ability to repay the LRBA. Careful planning and forecasting may be necessary before an SMSF trustee can make an informed decision about whether to enter into an LRBA.

Similarly, for any SMSF that has commenced an LRBA on or after 1 July 2018, the SMSF trustee should monitor and assess the effect that the proposed law has on each member’s TSB. If the member’s TSB is affected, the SMSF trustee may need to consider whether there are any strategies available to:

1          manage the increase in the relevant member’s TSB that results from their share of the outstanding balance of an LRBA; and

2          ensure that the LRBA can be repaid. For example, the repayment of an LRBA might be assisted by admitting additional members into the SMSF who have the ability to make NCCs. Naturally, the SMSF trustee should consider thoroughly the advantages and disadvantages of admitting additional members into an SMSF before making a decision.

Before implementing any strategies, consideration should be given to determine whether the implementation of a certain strategy might trigger the application of the general anti-avoidance provisions such as Part IVA of the Income Tax Assessment Act 1936 (Cth).

In relation to this aspect, we note that paragraph 4.24 of the Explanatory Memorandum to the Bill states:

…artificially manipulating the allocation of assets that are subject to [LRBAs] against particular superannuation interests at a particular time may be subject to the general anti-avoidance rules in Part IVA of the ITAA 1936 where such allocations formed part of a scheme that had the dominant purpose of obtaining a tax benefit.

(For a discussion on some general strategies to manage a member’s TSB, please refer to the following links:

 

Conclusion

As can be seen from the above, an SMSF trustee that is considering acquiring an asset via an LRBA should carefully plan and consider the potential effect of the proposed law on each member’s TSB where the members satisfy or are about to satisfy a relevant condition of release with a nil cashing restriction.

The existing and proposed law in relation to TSB is a complex area of law and where in doubt, expert advice should be obtained. Naturally, for advisers, the Australian financial services licence under the Corporations Act 2001 (Cth) and tax advice obligations under the Tax Agent Services Act 2009 (Cth) need to be appropriately managed to ensure advice is appropriately and legally provided.

DBA Lawyers offers a range of consulting services in relation to TSB and LRBAs. DBA Lawyers also offers a wide range of document services.

*        *        *

Note: DBA Lawyers hold SMSF CPD training at venues all around. For more details or to register, visit www.dbanetwork.com.au or call 03 9092 9400.

For more information regarding how DBA Lawyers can assist in your SMSF practice, visit

www.dbalawyers.com.au.

20 November 2018

The new ‘ipso facto’ regime and SMSFs

Joseph Cheung (jcheung@dbalawyers.com.au), Lawyer and Daniel Butler (dbutler@dbalawyers.com.au), Director, DBA Lawyers

The new law pertaining to ‘ipso facto’ clauses came into operation on 1 July 2018. This article highlights the relevance of the new law for SMSFs. Note that the law in this area is complex and a detailed and careful analysis is required to properly understand how the new ‘ipso facto’ regime operates.

Background: Purpose of the new law

‘Ipso facto’ is a Latin phrase that means ‘by the fact itself’. An ‘ipso facto’ clause is a provision in a contract that allows one party to terminate or modify the operation of a contract upon the occurrence of some specific event, regardless of otherwise continued performance of the counterparty. For example, in an insolvency context, a clause in a lease that allows one party to terminate the lease if the counterparty enters into external administration is an ‘ipso facto’ clause.

For the counterparty that is affected by an insolvency or formal restructure process, some negative consequences of ‘ipso facto’ clauses include (but are not limited to) the following:

  • the ability to successfully restructure could be reduced; or
  • the market value of a business entering formal administration could be destroyed; or
  • the business could be prevented from being sold as a going concern.

The introduction of the new law relating to ‘ipso facto’ clauses is part of the Federal government’s reform of Australia’s insolvency laws. This new law is aimed at enabling businesses to continue to trade in order to recover from an insolvency event.

Summary of the new law

Broadly, this new law applies to contracts entered into on or after 1 July 2018 and makes certain ‘ipso facto’ clauses that amend or terminate a contract unenforceable if the ‘ipso facto’ clause is triggered merely because:

  • the company is entering into administration (Corporations Act 2001 (Cth) (‘CA’) s 451E) ; or
  • a managing controller has been appointed over all or substantially all of a corporation’s property (CA s 434J); or
  • the company is applying for or undertaking a compromise or arrangement for the purpose of avoiding being wound up in insolvency (CA s 415D).

 

Generally, where a triggering event under any of the abovementioned three categories occurs, there is a ‘stay on enforcing rights’. Please note that there is further detail in each relevant section of the CA, covering aspects such as the timing of the stay and the Court’s ability to extend the period of the stay. However, a detailed examination of these sections is beyond the scope and purpose of this article.

Note also that there also exists exceptions to a ‘stay on enforcing rights’. We summarise these exceptions into four categories:

1          The right is a right under a contract, agreement or arrangement entered into after a triggering event.

2          The right is contained in a kind of contract, agreement or arrangement that is prescribed by the regulations or a kind declared by the Minister.

3          The right is a right of a kind declared by the Minister.

4          Certain parties (named in the CA) have consented in writing to the enforcement of the right.

Where a party wishes to enforce their rights despite a stay, they can apply for a court order. Broadly, the Court may issue an order if the Court is satisfied that this is appropriate in the interests of justice. (Refer to the CA ss 415E, 434K, 451F for further details about the criteria that the Court considers before making an order).

Despite the operation of a ‘stay on enforcing rights’, the new law does not prohibit the exercise of a right for any other reason. For example, where there is a breach involving non-payment or non-performance by one party, the counterparty party can pursue its legal rights.

Relevance of the new law for SMSFs

While the new law relating to ‘ipso facto’ clauses is not specifically targeted at SMSFs, it is relevant since there are an increasing number of SMSFs, especially SMSFs with corporate trustees, and these SMSFs often enter into various contracts that may contain ‘ipso facto’ clauses. The following are some common scenarios:

1          An SMSF owns business real property and leases it to either an unrelated third-party tenant or a related party tenant. A lease agreement is executed by the SMSF as lessor.

2          An SMSF invests by providing a loan to an unrelated third-party borrower. A loan agreement is executed by the SMSF as the lender.

3          An SMSF enters into a limited recourse borrowing arrangement (‘LRBA’) to purchase real property. The SMSF executes a loan agreement in its capacity as the borrower. The custodian/bare trustee company might also be included as party to the loan agreement.

Naturally, there are many other scenarios where an SMSF may enter into a contract.

In the first scenario, the lease may contain provisions stating that the lease agreement is terminated if the tenant enters into administration or the tenant fails to make a lease payment within a prescribed time period. Similarly, in the second scenario, the loan agreement may contain provisions stating that the loan agreement is terminated if the borrower enters into administration or the borrower fails to make a loan repayment within a prescribed time period. In both the first and second scenarios, the SMSF trustee may seek to rely on these provisions to terminate the agreement with the other party on the occurrence of a triggering event.

In the third scenario, the LRBA documents may contain provisions stating that the loan agreement is terminated if a certain triggering events occur, such as if the SMSF trustee enters into administration or the SMSF trustee fails to make a loan repayment within a prescribed time period. In the third scenario, the third party may try to rely on the provisions against the SMSF trustee upon the occurrence of a triggering event. In all three scenarios, there may be other clauses that deal with the consequence of the termination. It is important for SMSF trustees and advisers to know whether such clauses can be relied upon if a certain triggering event occurs. In certain circumstances, they may also have to decide whether any documents need to be updated in light of the new law relating to ‘ipso facto’ clauses.

The following is a brief checklist of questions for SMSF trustees and advisers to consider when reviewing contracts.

1          Is a certain clause in the contract an ‘ipso facto’ clause? For example, a clause stating that the contract is amended / terminated if the borrower enters into administration is most likely an ‘ipso facto’ clause.

2          If the clause in the contract is an ‘ipso facto’ clause, does an exception apply? Consider whether the right falls within one of the four categories of exceptions. If an exception applies, there is no ‘stay on enforcing rights’, and the relevant party can seek to rely on the ‘ipso facto’ clause to amend / terminate the contract.

3          If an exception applies and there is a ‘stay on enforcing rights’, can another clause be relied upon for the amendment / termination of the contract? For example, if the borrower has entered into administration and has also failed to make a loan repayment on time, the lender (ie, the SMSF trustee) may seek to terminate the loan agreement. A clause that states that the loan is terminated if the borrower enters into administration may be an ‘ipso facto’ clause and the lender may be prohibited from enforcing a right to terminate based on this fact. However, there may be another clause that states that any outstanding moneys can be recovered if a payment is not received on time. Further, the loan agreement may also specify that the full amount of the loan becomes payable if the borrower fails to make a loan repayment within the prescribed time period. This could allow the lender to recover the full loan amount plus interest plus costs, and to effectively bring the loan agreement to an end despite the other ‘ipso facto’ clause. Such a clause could protect the SMSF trustee in its capacity as a lender.

For completeness, please note that a ‘stay on enforcing rights’ relating to an ‘ipso facto’ clause does not by itself invalidate a contract. Furthermore, the law in relation to ‘ipso facto’ clauses may be subject to further change in the future. For example, the exceptions to ‘stay on enforcing rights’ may change, so it is prudent to review the law on a regular basis.

Conclusion

SMSF trustees and advisers should review all contracts entered into on or after 1 July 2018. SMSF trustees should also obtain documentation (such as LRBA documentation) from a quality supplier firm that has reviewed its documentation to ensure that it is up-to-date in light of this new law in relation to ‘ipso facto’ clauses.

The law in relation to ‘ipso facto’ clauses is a new area of law and where in doubt, expert advice should be obtained. Naturally, for advisers, the Australian financial services licence under the CA and tax advice obligations under the Tax Agent Services Act 2009 (Cth) need to be appropriately managed to ensure advice is appropriately and legally provided.

DBA Lawyers offers a range of consulting services in relation to individuals and advisers who have queries about how an ‘ipso facto’ clause affects an SMSF. DBA Lawyers also offers a wide range of document services. DBA Lawyers also confirms that its LRBA documentation has been reviewed to ensure that it is up-to-date in light of the new law relating to ‘ipso facto’ clauses.

*        *        *

Note: DBA Lawyers hold SMSF CPD training at venues all around. For more details or to register, visit www.dbanetwork.com.au or call 03 9092 9400.

For more information regarding how DBA Lawyers can assist in your SMSF practice, visit

www.dbalawyers.com.au.

13 November 2018

Ways to sidestep Labor’s ‘unfair and illogical’ tax grab on super

The Weekend Australian

James Gerrard

30 November 2018

Earlier this week, the man who may be our next treasurer, Chris Bowen, reiterated the ALP was not interested in amending its plans to scrap cash rebates for franking credits — a key element of income for many retirees.

The crux of the issue is that retirees, who in good conscience saved money in super, are having the rug pulled from under them. They are being treated as companies, effectively being taxed at 30 per cent on part of their ­income, with their tax-exempt super status being ignored.

I am going to run through several scenarios that would allow an investor to sidestep the franking credit plan, but first it does need to be put in perspective. The Labor Party’s plans to make a retrospective change to super not only ­adversely affects about one million retirees who are not eligible for a part or full age pension, but also undermines the confidence in the system.

Why would the younger generation bother trying to save for retirement by way of extra super contributions when governments (both Coalition and Labor) make tax-grabbing changes that are backward looking?

The result? Less money saved by Australians for retirement and a heavier reliance on the public purse.

Geoff Wilson, founder of Wilson Asset Management, says: “This is bad policy. What Labor doesn’t understand is that all Australians are intelligent. They will adjust their finances to minimise the impact of this money grab from Labor. The $5 billion-plus Labor talk about raising per year is discriminatory, unfair and illogical. The money they believe they will raise is a mirage.”

Wilson is best known among investors for a string of listed ­investment companies such as WAM Capital and WAM Leaders fund. In common with other LICs such as AFIC and Argo, Wilson will face a dilemma if the new rules become reality — the LICs will lose out as investors steer away from products where the franking credit attractions have been removed for retired investors.

Indeed, Wilson said he would be forced to convert all his group’s LICs to unit trusts if the ALP win, and other LICs would no doubt do the same creating legal costs for every LIC in the market.

As professionals such as Wilson think the issue through, the biggest problem is that not all retirees will make the right decision when these changes arrive and some will expose themselves to riskier investments chasing unfranked dividends. Timing is also an issue. With the royal commission putting a dampener on bank share prices, anyone thinking of bailing out of fully franked bank shares to unfranked investments will lock in a loss of 10 per cent over the past 12 months.

For the people thinking about what they can do to counteract the impact of the policy, here are three potential workarounds:

1. If you don’t want to lose your exposure to fully franked blue-chip shares such as the banks, BHP and Wesfarmers, one option is to sell the shares the day before they declare their dividend, known as the ex-dividend date. You then buy the stock back the next day after the share price falls. The problem with this approach is that the share price usually falls by the cash dividend amount alone, not by the total value of the cash dividend and franking credits.

2. An alternative strategy that is gaining traction with retirees is to move into listed property investments via real estate investment trusts, which are seen by many as the closest comparable investment to fully franked bank shares. REITS are property trust structures that trade on the ASX. Unlike normal shares on the ASX, REITS do not withhold tax as all distributions are taxed in the hand of the investor.

3. For the more passive investor, there are several ETFs that can invest in unfranked investments such as Betashares Legg Mason Real Income Fund that holds a portfolio of largely unfranked property, utilities and infrastructure assets.

While it is still too early to panic, the writing is on the wall with regard to the scrapping of cash refunds on excess imputation credits.

James Gerrard is the principal and director of financial planning firm FinancialAdvisor.com.au.

People in the middle lose out in ALP’s franking credit crunch

The Australian Business Review

James Gerrard

23 November 2018
If the ALP comes to power and ­delivers on its threat to scrap cash rebates on franking credits, what could you do?

An investor might reframe the question in this manner: is it better to take drastic action and sell down all self-managed superannuation fund assets, transferring the wealth to the investor personally and in so doing remove the cost, administration and trustee responsibilities attached to running a SMSF?

After the public uproar that ­resulted from the initial policy ­announcement, Labor revised its proposal to allow SMSFs with at least one member receiving a Centrelink pension or allowance as at March 28, 2018 to continue to be eligible for cash refunds of excess franking credits. The outstanding problem with the policy proposal is that it discriminates against people in the middle. People with low income and assets are exempted and people with significant assets in super are only partially affected.

The reason the rich continue to benefit is that with the relatively recent balance transfer caps, only $1.6 million can be held in a tax-free super pension per person.

For those with money in super above $1.6m, the excess needs to be held in the super accumulation account, taxed at up to 15 per cent on income and gains.

In other words, because the ultra rich will still have significant funds in the super accumulation account that attracts 15 per cent tax, they will continue to use franking credits to reduce tax on the accumulation account, and therefore may be largely unaffected by the policy change.

But it is the people in the middle who are hardest hit, deemed too wealthy to receive Centrelink benefits, but not wealthy enough to have more than $1.6m in super. They feel the full force of the Labor imputation credit changes.

For the $1m SMSF with a ­retired homeowner couple as ­trustees and members, they’re over the threshold of $848,000 to receive a part age pension, and thus targeted by the Labor policy proposal. If they held 25 per cent of the super fund in fully franked shares paying an average 6 per cent dividend, that equates to franking credits of about $6500 a year at risk of being lost.

Some SMSF trustees may cop it on the chin, while others may close the SMSF and deal with the money outside super. (This example is typical; the average cash refund cheque is close to $6000).

Exploring that path in more detail, if the investments are transferred out of super into a joint personal investment account and generate an average income return of 6 per cent, with 25 per cent of the income being from fully franked dividends, that equals grossed-up taxable income of $66,428 including $6428 of franking credits.

If each spouse is allocated half of the income, $33,214 per spouse, tax payable is $2872. After franking credits are
applied, there is no tax payable, with $342 in franking credits still to spare.

The big drawback to this approach is that you’re now exposed to capital gains tax personally. So it depends on how you manage your investments as to whether this approach works for you.

If there is moderate turnover of the portfolio with gains being realised each year, not only will your investment income be taxed, but you may end up with a large tax bill due to realised capital gains.

Another consideration is that the policy may change over time. Labor may further water down the policy or even reverse it.

If it works out best to hold money inside super in future, irreversible damage would have been done by those who shunted money out of super, which, due to a combination of contribution caps and work tests for those over 65, makes it extremely difficult for people to get money back in super down the track.

And it doesn’t stop there. ­Estate planning also needs to be considered.

As you can see, what appears a simple policy announcement will have an enormous ripple effect on millions of people in retirement and for their children.

In summary, there are so many variables that working out the best outcome, both now and into the future, is confusing and highly mathematical.

The policy is estimated to bring in $59 billion in savings over the next 10 years for Labor.

But the people most likely to be affected are not the mega-wealthy but the hard-working mums and dads who diligently contributed into super over the past 20 years under the assumption it would be a protected environment that would allow them to draw an income stream in retirement.

James Gerrard is the principal and director of Sydney financial planning firm www.FinancialAdvisor.com.au

Related articles:

http://saveoursuper.org.au/alps-franking-credits-policy-targets-shareholders-with-low-taxable-incomes/

http://saveoursuper.org.au/ways-to-sidestep-labors-unfair-and-illogical-tax-grab-on-super/

Minimising lost opportunity: Payments above Account-Based Pension (‘ABP’) minimum

Joseph Cheung (jcheung@dbalawyers.com.au), Lawyer

and

Daniel Butler (dbutler@dbalawyers.com.au), Director, DBA Lawyers

Significant time has passed since the introduction of the transfer balance cap (‘TBC’). During this period, many have become aware of the potential trap caused by the TBC for SMSF members who receive payments above the account-based pension (‘ABP’) minimum annual amount, and have responded by implementing various strategies to avoid this trap. This article shows that timely action can minimise any further opportunity cost resulting from the trap.

What opportunity has been lost for those who have already been caught by the trap?

For members who have not implemented a strategy, the capital supporting their ABP(s) is reduced by the amount of the pension payment(s), including the amounts above the relevant ABP minimum(s). However, there is no corresponding debit to the member’s transfer balance account (‘TBA’)!

Where the member had ‘maxed out’ their TBC, they cannot add any further capital to commence a new pension that is in the retirement phase (ie, a pension that will obtain a pension exemption). Therefore, drawing more than the minimum payment will exhaust the capital supporting the ABP(s) significantly faster than would otherwise be the case. Where the member had not ‘maxed out’ their TBC, there will be limited capacity to add further capital to commence a new ABP.

EXAMPLE

As at 1 July 2017, Ken is 66 years old and has an existing ABP with $1.6 million capital supporting his ABP. He does not have any other pensions. He also has an accumulation superannuation interest of $100,000. On 1 July 2017, his personal TBC is $1.6 million. A credit of $1.6 million applies to Ken’s TBA.

On 1 August 2017, the SMSF trustee makes a payment of $200,000 to Ken. As Ken is 66 years old, the relevant ABP minimum payment for Ken is $80,000 (ie, $1,600,000 (account balance) x 5% (percentage factor)). Accordingly, this payment of $200,000 exceeds the ABP minimum payment for Ken by $120,000.

The result is that the capital supporting the pension is reduced by $200,000, with $1.4 million remaining (ignoring any growth and expenses). However, there is no corresponding debit to Ken’s TBA, which still shows a credit balance of $1.6 million. As Ken’s TBC is ‘maxed out’, he cannot add any capital to start a new pension.

If Ken does nothing and continues to receive pension payments greater than the relevant ABP minimum payment in this financial year (‘FY’) or in future FYs, the capital supporting the pension will be exhausted significantly faster than would otherwise be the case. Ken would not be able to add any capital to start a new pension.

How can members minimise lost opportunity?

DBA Lawyers understands that the following two-step strategy has been contemplated by many advisers in the SMSF industry to address the potential trap:

Step 1: Pay all amounts above the relevant ABP minimum(s) as a lump sum payment from the member’s accumulation interest.

Step 2: Where there is no accumulation superannuation interest or the accumulation superannuation interest is insufficient to pay the amounts in excess of the relevant ABP minimum(s), these excess amounts are to be paid as a partial commutation of the relevant ABP.

For members who already had an ABP on 1 July 2017, the effectiveness of the above strategy is maximised if it were documented on or shortly after 1 July 2017, so that the strategy applies prospectively before the payment of any amount above the relevant ABP minimum. In those circumstances, the members would have avoided the trap. For the avoidance of doubt, the strategy document should have been dated when executed. Note that backdating or falsification of a document is a serious matter that can result in substantial penalties.

As mentioned, some members may not have been aware or taken action. However, if the strategy is properly documented, these members can minimise any future lost opportunity.

EXAMPLE

This is a continuation of the earlier example. As at 1 July 2018, Ken is 67 years old and has an existing ABP with $1.4 million remaining. He does not have any other pensions. He also has an accumulation superannuation interest of $100,000. On 1 July 2018, Ken’s TBA still shows a credit balance of $1.6 million.

On 1 November 2018, the above two-step strategy is properly documented.

On 1 December 2018, the SMSF trustee makes a payment of $200,000 to Ken. As Ken is 67 years old, the relevant ABP minimum payment for Ken is $70,000 (ie, $1,400,000 (account balance) x 5% (percentage factor)). Accordingly, this payment of $200,000 exceeds the ABP minimum payment for Ken by $130,000.

As the strategy has been documented properly, the $70,000 is a payment from the capital supporting Ken’s pension, the $100,000 is a payment from Ken’s accumulation superannuation interest, and the $30,000 is a payment as a partial commutation of the ABP.

The result is that the capital supporting the pension is reduced by $70,000, with $1,330,000 remaining (ignoring any growth and expenses). Ken’s accumulation superannuation interest is fully exhausted, ie, reduced to nil. There is also a corresponding debit of $30,000 to Ken’s TBA, which now shows a credit balance of $1,570,000 (assuming no other events give rise to a debit/credit). As Ken’s TBC is not $1.6 million, he can add capital of up to $30,000 to start a new pension.

Alternatively, if no strategy had been documented, the result would be that the capital supporting the pension is reduced by $200,000, with $1.2 million remaining (ignoring any growth and expenses). However, there is no corresponding debit to Ken’s TBA, which still shows a credit balance of $1.6 million. As Ken’s TBC is ‘maxed out’, he cannot add any capital to start a new pension.

The above example shows that once the two-step strategy is documented, the capital supporting the pension will be exhausted slower than would otherwise be the case if the member had not put into place such a strategy. Even if a member had been caught in the trap, a result of documenting the strategy is that the lost opportunity resulting from the trap is limited to the period in which there is no strategy in place. Subsequent payments above the relevant ABP minimum(s) made in accordance with the strategy would not be exposed to the trap.

Can the strategy be documented to apply retrospectively?

Unfortunately, for members who have been caught in the trap, it is unlikely that the ATO would accept documentation that applies a strategy retrospectively, ie, after the payment of the amount above the relevant ABP minimum(s) has occurred.

In relation to the partial commutation of pensions, the ATO’s view, as expressed in TR 2013/5, is that the member must consciously exercise their right to exchange something less than their full entitlement to receive future pension payments for an entitlement to be paid a lump sum. Where no documentation exists either before or at the time of payment, it is hard to prove that the member consciously exercised their right. The ATO could decide that there was no partial commutation and that the amount was just paid as a pension payment in excess of the relevant ABP minimum(s). Accordingly, any strategy involving a partial commutation should be documented prior to the time of payment.

Similarly, where the payments are allocated and the strategy documented ‘after the fact’, the ATO might take the view that the payments did not come from an accumulation interest as it could not be proven that this was the parties’ intention at the time of payment, and it was not a valid partial commutation. The ATO could then treat the payment as a pension payment in excess of the relevant ABP minimum(s). A conservative approach is to have relevant documentation completed and signed before the payment of the amounts in excess of the ABP minimum payment.

Based on the above reasoning, members should take timely action to document a strategy so that the strategy can apply prospectively to the payment of any amount above the relevant ABP minimum.

Conclusion

SMSF members who have been caught in the trap caused by the TBC need to take timely action and prospectively record a strategy for payments above ABP minimums.

DBA Lawyers offers documentation to prospectively record the above strategy for any member who wishes to protect the capital supporting their pension(s) from being exhausted beyond the relevant minimum pension amount. For more information, please visit https://www.dbalawyers.com.au/payments-abp-minimum/.

*        *        *

Note: DBA Lawyers hold SMSF CPD training at venues all around. For more details or to register, visit www.dbanetwork.com.au or call 03 9092 9400.

For more information regarding how DBA Lawyers can assist in your SMSF practice, visit

www.dbalawyers.com.au.

15 October 2018

ALP’s franking credits policy targets shareholders with low taxable incomes

15 October 2018

Jim Bonham

“Having a non-means tested government payment solely on the criteria that you own shares and giving people a refund when you haven’t actually paid income tax for the year that the refund covers, what’s the economic theory behind that?” asked Opposition Leader Bill Shorten recently, and reported by Phillip Coorey in the Australian Financial Review on 12 October 2018.

Mr Shorten is  talking about refundable franking credits, but actually franking credits are means tested (because they’re taxable income and our progressive tax scales are a form of means testing), and you have paid income tax (because franking credits are also pre-paid tax) and, finally, there is an economic theory (to ensure gross dividends are taxed as ordinary income).

Unfortunately, that’s not the way the ALP sees it.

Shadow Treasurer Chris Bowen, said refundable franking credits are “a concession”, “unfair revenue leakage” and “a generous tax loophole” when describing the ALP’s plan to stop the refunding of unused franking credits  (see SuperGuide article https://www.superguide.com.au/smsfs/shorten-retirement-tax-refunds-franking-credits  and and the ALP’s policy document, https://www.chrisbowen.net/issues/labors-dividend-imputation-policy/ )

Those comments are not right either.  Refundable franking credits are part of an unfortunately convoluted and widely misunderstood process, but their function is straightforward: to ensure that Australian company profits distributed to Australian shareholders are taxed in the hands of the owners (shareholders) rather than the company, in exactly the same way as income from any other source.  The company is only taxed on that part of its profit which is kept in the company for internal use, and not distributed.

In our present system of refundable franking credits therefore, there is no concession, no leakage and no loophole.

In the discussion referenced above, the Shadow Treasurer also said “While those people [with low taxable incomes] will no longer receive a tax refund, they will not be paying additional tax” which is a prime piece of Orwellian double-speak.  It’s not correct, and shareholders on sufficiently low incomes will find that their franking credits are simply confiscated as tax – money they get now will no longer be received and they will have less to live on.

Australians on low incomes will lose franking credits, unless they receive a part or full Age Pension. After strong protests that convinced the ALP that its policy would actually harm those on low incomes, they announced the “Pensioner Guarantee” – an exemption from the policy for Age Pensioners who hold shares directly, and for SMSFs where at least one member received the Age Pension or a government allowance before 28 March 2018 – but that still doesn’t help non-pensioner shareholders with low incomes.

In this article, I dig into this subject in more detail, particularly for those who hold their shares directly in their own names, to show what the ALP proposal really means and how it would operate.

I’ll show that the policy can cause very substantial loss of income for direct shareholders, especially those on low or middle incomes.  Retirees will simply not be able to suck up the sort of losses involved and we can expect some creative asset reduction to get under the Age Pension asset test threshold, or a major restructure of the investment portfolio to avoid franked dividends.

Dividend imputation, and how franking credits work

In the bad old days when dividends paid from company profits (taxable in Australia) were double-taxed, it worked like this:  the company paid tax at the corporate rate (currently 30%) on the relevant profit; the remainder (70% at current rates) was sent as a dividend to the shareholders, who then paid further tax on it as part of their ordinary income.

In 1987, the Hawke-Keating government decided to remove this double taxation of dividends, introducing a dividend imputation system similar to what we have today, except that franking credits were non-refundable.

Although the company still paid tax at the corporate rate (currently 30%), any of that tax which was associated with profits paid out as a dividend was reclassified as a “franking credit” and held by the ATO as a pre-payment of tax on behalf of the taxpayer – very similar to the PAYE system

The franking credit was also treated as part of the shareholder’s taxable income.  In other words, the gross dividend, which is the franking credit plus the dividend, was added to any other taxable income when calculating the shareholder’s income tax.  The franking credits, being pre-paid tax, were then subtracted from the calculated tax owing, so that in the end the gross dividend was taxed just like any other income.

For high-income shareholders, whose tax liability exceeded the value of the franking credits, this system had the effect of transferring the liability for tax on company profits from the company to the shareholder.

However, for low-income shareholders the situation was different.  If there were franking credits left over after paying the tax, the ATO simply kept the excess.  (This outcome is what is meant by “non-refundable”). Taxpayers who would have paid no tax at all if the same amount had been earned from employment, actually paid the corporate tax rate on their dividends.  Their dividend income was “taxed in their own hands”, but not taxed like other income.

In 2000, the Howard-Costello government made unused franking credits refundable to the taxpayer, creating the current system in which gross dividends are always taxed as shareholder’s income, regardless of the shareholder’s tax rate.

Here’s a simple example to show how the three systems treat low and high income taxpayers.  For this example, “low income” means too low to pay tax in our current system and “high income” means over $180,000 so the marginal tax rate is 47% (including the Medicare levy).  It’s also assumed that the gross dividend is not large enough to alter the taxpayer’s marginal tax rate, and today’s tax rates are used.

The table shows how much money, after tax, ends up in the shareholder’s pocket as a result of $100 profit earned by the company and distributed as a dividend. Clearly, low-income recipients of franked dividends will be the hardest hit if the ALP re-introduces non-refundable franking credits.

System After tax income from $100 profit
  Low income High income
Double taxation (prior to 1987) $70 $37
Non-refundable franking credits (Hawke-Keating) $70 $53
Refundable franking credits (Howard-Costello) $100 $53

Dividend imputation with non-refundable franking credits  was a have-your-cake-and-eat-it-too system for the government, where that part of a company’s profits distributed as dividends was taxed at either the corporate or the personal tax rate, whichever gave the higher result.  This is the system the ALP wants us to return to – Age Pensioners (mostly) excepted.

So who is most affected by the proposed policy? What is their income? How much income will they lose?  How effective is the Pensioner Guarantee? Let’s look at these questions in some detail.

Significant loss of income under ALP proposal for direct shareholders

People who hold shares directly, outside of superannuation, may be rich or struggling; they may be retired or in their youth; they may rely on dividends from shares for all of their income, or just a part of it; they may have other taxable income from dividends, rental, employment etc.  They might also receive non-taxable income from a superannuation pension, but that has to be looked at separately and does not affect what happens with their taxable income.

Whatever the circumstance, the introduction of the ALP’s policy will result in either a loss of income or, if the shareholder’s income is high enough, no change.  No one gains except the government.

If a shareholder is going to lose income under the ALP policy, the actual amount depends on total taxable income, the amount of gross dividends as a percentage of the total, and whether the taxpayer is entitled to SAPTO (and if so, whether single or a member of a couple).

Incidentally, wherever I use the phrase “entitled to SAPTO”, it is to be understood that the entitlement only applies if the income is below the appropriate threshold.  Above that, the “entitled to SAPTO” and “not entitled to SAPTO” curves in the graphs to follow are, of course, identical.

Fig 1 presents the loss of income which would result from the ALP proposal for a single senior shareholder entitled to SAPTO, where the gross dividends received constitute 25%, 50%, 75% or 100% of the shareholder’s total taxable income.

For example, if gross dividends represent 100% of a taxpayer’s income, the introduction of the ALP proposal will be most financially devastating for single senior Australians earning about $33,000 a year but will also affect those earning up to about $138,000 a year. If gross dividends represent 75% of a taxpayer’s income, the ALP proposal will most severely hurt single senior Australians earning about $33,000 a year  but will also affect those earning up to about $75,000 a year

In all scenarios, single senior Australians with low to moderate incomes will be most affected by the ALP’s proposal to ban franking credits refunds.

Figure 2 shows the same results, but for a senior taxpayer who is a member of a couple.  Note this graph is just one partner’s share of both the income and the loss.  The shapes of the curves are a bit different from those in Fig 1 because of the complicated structure of our tax scales.

Note: In particular, for a couple, if gross dividends make up 50% or less of total income, the worst loss occurs at an income (each) of about $22,000.

Finally, Fig 3 shows the same results for a younger taxpayer who is not entitled to SAPTO.

In each of these three graphs the curves are skewed towards lower incomes and the greatest amount of income loss occurs at a taxable income of between $22,000 and $33,000 depending on the individual case.  That’s hardly a huge income, yet in the worst case the ALP proposal will reduce this income by up to $10,000 per year, depending on the percentage of franked shares contributing to taxable income.  The proportional loss is savage.

For those who don’t qualify for SAPTO, the maximum loss of income occurs at lower taxable incomes and is not quite as large, but it is still very significant in relation to the level of income

This is just another slap in the face to seniors who, in recent years, have suffered the doubling of the Age Pension asset test taper rate, dramatic upheaval in the structure of superannuation in retirement and now, for share investors, the threat of losing some or all of their franking credits.

Many retirees must question why they put so much effort in their younger years into saving and learning how to invest, only to have their assets and income so badly trashed by continually changing rules.

What about the Age Pension?

When introducing this policy, the ALP claimed that it would mostly affect wealthy retirees.  A strong backlash led to the Pensioner Guarantee (exemption) and the claim that they were thus protecting those less well off.

However, that did nothing for those who fail to qualify for the Age Pension but still don’t have much income.  We need to see where in Figs 1 or 2 the Age Pension might cut out.

To keep things as simple as possible, we’ll just look at the top curves in Figs 1 and 2, which assume that gross dividends make up all the taxable income.  In both cases, the worst loss occurs for a taxable income of about $33,000, and if we assume a gross dividend yield of 6% (approximately the average for fully franked shares in the ASX 200) the value of the shares needed to generate that income is $550,000.

The upper asset test threshold for the Age Pension is different for singles and couples, and for those who own their own homes:

Asset test upper threshold
Homeowner Not homeowner
Single $564,000 $771,000
Couple (each) $424,000 $511,000

 

None of these figures are very far from $550,000.  What that means is that someone who just fails to qualify for the Age Pension, and so is not excluded from the ALP policy, will probably find themselves facing close to the maximum loss of income.

How will people respond?

With incomes at these levels, nobody’s going to just suck up the sort of losses involved, so expect either (a) some creative asset reduction to get under the Age Pension asset test threshold, or (b) a major restructure of the investment portfolio to avoid franked dividends.

The first alternative, that is, creative asset reduction, is likely to trap the person into permanent dependence on the Age Pension, restricting a person’s ability to improve her financial position in future or to deal with major health or care issues late in life.  The second alternative, restructuring the investment portfolio, could adversely affect the risk of the portfolio producing poor returns, leading to an inadvertent slide onto the Age Pension.

Either way the objective of the ALP proposal is thwarted, which makes it rather pointless to make people jump through these hoops, while putting more people on the Age Pension

SMSFs also hit by ALP proposal

The ALP’s proposal also applies to shares held within a self-managed super fund.

If an SMSF is in accumulation mode, then the tax rate on investment earnings and discounted capital gains is 15%. In such circumstances, if gross dividends make up more than half the total income, some of the franking credits will be lost.  I suspect most people caught in this situation will restructure their investments to bring gross dividends down below 50% of income.  Such a strategy solves the tax problem, but may adversely alter the SMSF’s risk profile.

SMSFs in pension mode are in a much more difficult situation.  They pay zero tax on fund earnings, but under the ALP proposal they would lose all of their franking credits, which could be up to 30% of their current income.  Portfolio restructure is one option to avoid this tax (although it would mean abandoning shares paying franked dividends), as is simply reducing (spending) assets so as to bring their value low enough to qualify for the Age Pension – in both cases with the possible consequences outlined earlier.

Unfortunately, reducing the value of shares held in the SMSF – as a deliberate strategy or simply to supplement income – to the point where a retiree qualifies for a part Age Pension still won’t protect the franking credits. The Pensioner Guarantee does not apply to SMSF members who qualify after 28 March 2018, so retirees in this situation will probably consider closing their SMSF and reinvesting outside super.

SMSFs in pension mode seem to be the main target of the ALP’s proposal, and the Shadow Treasurer’s statement (https://www.chrisbowen.net/issues/labors-dividend-imputation-policy/ ) specifically refers to the fact that some SMSFs get very large refunds of franking credits.  Well yes, some did, but that was largely eliminated by capping superannuation pension accounts at $1.6 million.  Meanwhile, lots of people have relatively small SMSF pension accounts.

If the real problem that the ALP is trying to address is the fact that SMSFs in pension mode pay no tax, then that should be addressed directly with full consideration of context including large funds as well as SMSFs.  It is a fundamental and complex issue and simply changing the way dividends are taxed is not the way to deal with it.

Destructive and unfair tax policy

Halting the refund of excess franking credits is a very destructive policy for those who hold shares directly or in an SMSF, especially in pension phase

Such a proposal puts a severe strain on retirees whose taxable income is fairly low unless they can find a way to restructure their investments or qualify for the Age Pension, but it has little or no effect on wealthier people – unless their investment is through an SMSF in pension mode.

Likely responses to the policy would see some people driven to the Age Pension, at long-term cost to themselves and the government.  Others will close their SMSF purely to get under the umbrella of the Pensioner Guarantee.  Some may decide to remove all Australian shares paying franked dividends from their portfolios – how is this good for themselves or the country?

Income tax is often arbitrary and complex, but the basic principle of dividend imputation with refundable franking credits is simple and sound:  to ensure profits distributed as dividends are taxed as normal income in the hands of shareholders.  Why mess that up?

The ALP policy is the antithesis of a well-designed tax policy, a direct slap in the face to the notion of a progressive tax system, and an extraordinary proposition to have come from the ALP.

Exempting Age Pensioners who hold shares directly from this policy was painted as supporting those on low incomes, but really it was just a way of papering over part of a problem and hoping no-one would notice the rest.

Technical note: All tax calculations in this article use 2018-19 tax rates, and include LITO, LMITO, SAPTO (if relevant) and the Medicare levy.  The Age Pension asset test thresholds are applicable from September 2018. For more information on income tax rates see SuperGuide article https://www.superguide.com.au/boost-your-superannuation/income-tax-rates. For more information on Age Pension assets test, see SuperGuide article https://www.superguide.com.au/accessing-superannuation/age-pension-asset-test-thresholds .

About the author: Jim Bonham

Dr Jim Bonham is a retired scientist and R&D manager, who is deeply concerned about the appalling instability of the regulatory environment around superannuation, retirement funding and investment generally. If the ALP policy is implemented, he will be affected by the loss of franking credits in relation to shares held directly, and within an SMSF. 

Copyright: Jim Bonham owns the copyright to this article. Copyright © Jim Bonham 2018

First published on 15 October 2018 on SuperGuide: https://www.superguide.com.au/retirement-planning/alps-franking-credits-policy-targets-shareholders-low-taxable-incomes

On 16 October 2018 Jim Bonham sent the following email to Bill Shorten and Chris Bowen:

From: Jim Bonham [mailto:jim@bonham.id.au]
Sent: Tuesday, 16 October 2018 9:19 AM
To:Bill.Shorten.MP@aph.gov.au‘ <Bill.Shorten.MP@aph.gov.au>
Cc:Chris.Bowen.MP@aph.gov.au‘ <Chris.Bowen.MP@aph.gov.au>
Subject: Franking credits

Dear Mr Shorten,

I was dismayed to read the following quote, attributed to you, regarding refundable franking credits:

“Having a non-means tested government payment solely on the criteria that you own shares and giving people a refund when you haven’t actually paid income tax for the year that the refund covers, what’s the economic theory behind that?”  (https://www.afr.com/news/bill-shorten-promises-biggest-preelection-policy-agenda-since-gough-whitlam-20181011-h16ju0 )

The facts are:

  1. Refunds of franking credits to shareholders with low taxable income are means tested, because franking credits are taxable income and the progressive nature of income tax system effectively applies a means test.
  2. You have paid income tax, because the franking credit is treated by the ATO as a pre-payment of tax.  The refund to those on low taxable incomes occurs because the pre-payment is an over-payment.
  3. There is an economic theory.  The dividend imputation process was designed to ensure that company profits distributed as dividends are taxed in the hands of the shareholder (the company is only taxed on profits retained for internal use).  Refunding franking credits in excess of the shareholder’s tax obligation is essential to ensure that the gross dividend is taxed in the same way as other income.  Failing to refund excess franking credits, as the ALP is proposing, forces those on low taxable incomes to pay a higher rate of tax on gross dividends than they would if the same income were earned in any other way.

 

Please abandon the policy of making franking credits non-refundable.  It hits those with low taxable incomes the hardest, and makes living in retirement on your own resources far more difficult for self-funded retirees.

Jim Bonham

How did both major parties get super so wrong?

The Australian

1 October 2018

Robert Gottliebsen – Business Columnist

Both the government and the opposition have the same problem — they both have difficulty in devising sensible superannuation and retirement policies.

And this raises the question of why can’t they get it right? Why do they make so many mistakes?

In the Weekend Australian I set out how shadow treasurer Chris Bowen simply got his franking credits policy wrong.

But go back a few years and the then treasurer Scott Morrison and his assistant Kelly O’Dwyer put forward a set of horrendous superannuation policies and even went as far as saying they were not retrospective when of course everyone knew they were.

Those bad policies almost cost the Coalition the election. They were lucky because many of their backbenchers took the trouble to talk to people and understand what was happening and forced through policy adjustments that were at least a substantial improvement on the original ideas.

And in the current ALP fiasco my understanding is that, in a similar way to the Coalition, intelligent backbenchers are talking to the voters and are starting to understand the looming disaster and are desperately looking for a way around the problem without admitting error.

Let me help them. The best way is to abandon the policy altogether, but if you need a compromise then limit the amount of cash franking credits that can be claimed to, say, about $15,000.

The cap being floated in ALP circles is $10,000 but I think that is too low. But whether it be $10,000 or $15,000, the problem is we are introducing legislation that is complex, will raise very little money and makes retirement just that much more complex.

We can fix that over time, and a $15,000 annual cap to cash franking credits will solve most of the problems among the battlers who are struggling to fund their own retirement. The problem both the Coalition and the ALP face in superannuation matters is that, in the first instance, the politicians have very generous super arrangements and don’t do their homework on the rest of the population. Even worse, in the public service the people at the top are mostly on incredibly generous benefits and are members of the so-called “$10 million club” with benefits that are way in excess of what is available to the general public.

While that has been changed for the most recent recruits, the people at the top of the public service are mostly living in a different world to the rest of the country. So when they look at super and retirement matters they simply have no idea what is taking place. My understanding is Chris Bowen, when devising his super franking credit disaster, actually went to the public service to have it evaluated and they came back with the thumbs up, which made him confident that the concept was a legitimate tax arrangement that would take money from the rich.

As we all now know, the policy is a savage blow to ordinary Australians trying to fund retirement, with about 1.4 million people in the ALP’s sights and hardly a rich person among them.

I believe we are looking at a phenomenon that cripples both parties. The first step in solving the problem is that ministers in areas like superannuation need to understand that the public service is of limited value to them.

They have to send their people out into the real world and, as the Coalition found, the best advice came from the backbenchers who usually have the time to be in touch with the electorate.

Ministers and shadow ministers in Canberra (and also in state governments) surround themselves with ministerial staff who second-guess the public service. Too often the ministerial staff are “yes” people with no depth to their knowledge outside of politics.

This situation has caused many talented people to either leave the public service or simply not join it. Once we had a proud public service that was as far as possible independent, but we are now seeing in so many areas public service advice simply doesn’t have the same standards it once did.

Nothing is going to happen in the short term, but down the track ministers are going to have to think about how they restore the quality of public service advice so that they don’t get caught in situations as we have seen in superannuation and retirement from both parties. When Australians reach their 40 and 50s they make long-term plans for their retirement in accordance with rules that exist at the time. When past governments changed rules the old rules were grandfathered so they were not retrospective.

It was the Coalition that decided there should be retrospective legislation. At least Bowen is being honest and is saying he is changing the rules retrospectively, but that doesn’t validate his policy. For what it is worth I admire the shadow treasurer for the fact that he is open about the tax measures he is planning to undertake.

Traditionally opposition treasurers keep their mouths shut and introduce the nasties once they get into office.

For real Scomentum, drain the billabong

The Spectator

26 September 2018

David Flint

Our political class are being seen more and more as arrogant and as out of touch as the French aristocracy were in the lead-up to the revolution.

The people who decide elections— those who are not rusted-on Coalition or Labor voters— see little difference between them. Most have neither the time nor the interest to go into the detail which would demonstrate that, however inadequate government policy is, Labor’s is worse. And the only news most see is on TV bulletins where someone from the gallery typically presents politics through a left-wing prism

Seeing little difference in policy, the undecided see only one thing, disgraceful self -indulgence, the latest being for many the last straw. They will make the government pay, however much Labor is involved.

Before I discuss that, the crucial thing in any poll, at least in Australia, is the ‘two-party preferred vote’ the two-party preferred. Everything else is décor.

The latest, 44/56, demonstrates that Scott Morrison has to show his policies are significantly different and what the people want. He has at least acted to retain the Catholic vote which Simon Birmingham lost, a vote Menzies long ago seduced from Labor by acting on the grossly inequitable treatment of the parochial school system.

Following the constitution, Canberra should otherwise keep its nose out of schools, as should all politicians. Using schoolchildren as political props does not attract votes. In fact, most voters are sickened by this form of child abuse.

To win, Scott Morrison must adopt policies significantly different from Labor’s on energy, the rate of immigration and pouring taxpayers hard-earned money down the drain. He should spend a few hours with Tony Abbott who’ll put him right.

He should also announce a plan to drought-proof the country, with Stage 1 to be completed in five years. This should incorporate the three B’s —the Bradfield, Beale and Bridge Plans. He can borrow this from Alan Jones who’ll be delivering a major address on this next week, see www.norepublic.com.au

Morrison should also apologise to the Liberal base who’ve walked out or gone on strike by repealing the dopey superannuation legislation he and Kelly O’Dwyer pushed through. Not only does this offend just about everything the Liberal Party stands for, it has encouraged Labor not only to do worse but to announce it knowing that the Liberals can’t complain — some achievement.

He must also appoint a real and not a jack-in-the-box Minister of Defence, one whom the military would respect. Morale is at an all-time low from the Canberra-assisted campaign against war heroes, the way cultural Marxists are running recruitment and the raids on the defence budget, bigger even than Labor’s, to shore up government seats.

The last straw for many undecided was the award to two politicians of travel so luxurious as to be beyond the wildest dreams of most Australians. This involves a three-month stay in luxury accommodation in New York at a cost of about $100,000 each. Neither the Liberal, Anne Sudmalis, nor Labor’s Jenny Macklin, can make the usual feeble argument that this will enable them to better represent their constituents by improving their understanding of the UN, global government and how and why our sovereignty is being sold out to the rule of international bureaucrats from an organisation dominated by foreign dictatorships.

Almost as soon as they return, both will take their parliamentary superannuation, possibly picking up ‘jobs for the boys’ and well-paid postings in foreign corporations, banks and other places.

While some will recall Ms Macklin’s role as a great distributor of taxpayer-funded largesse, Ms Sudmalis only rose to prominence with her recent unpersuasive complaints about ‘bullying’ within the Liberal Party. Her face, but not her name, was however well-known by being placed strategically behind the PM during Question Time, that fourth-rate version of the real question time at Westminster where the Speaker chooses the questioners. Her involvement in this farce may not have raised her prestige, her job being either to nod approval to whatever ministers read from their prepared answers or to laugh at their attacks on the opposition.

As a result of ‘bullying’ and not because the seat will be among the first to fall in the election, Ms Sudmalis announced she will seek re-election.

Since neither indulgence involves Bronwyn Bishop, the mainstream media has not continued to pursue them. Nevertheless, in workplaces, kitchens, clubs and pubs across the country and in people’s memory, this rort is a subject of outrage where the common lament is that this time the politicians have gone too far.

Marie-Antoinette, who never even saw the sea, was guillotined for less. In fact, she never said of the starving poor “Let them eat cake”. That was an invention of the fake media of the day. In fact, all of the charges against her were concocted by the Jacobins, as if they were Democrats undermining a Republican judicial nomination in Washington.

Meanwhile, in Australia, the parties and their leaders do not seem to realise how this grotesque indulgence is a slap-in-the-face for the farmers who are persecuted constantly by the politicians and bureaucrats who have stolen their water and turned vast parts of their land into carbon sinks to venerate the fashionable and foreign religion of global warming.

Nor do they see how this excess has so outraged those hard-working taxpayers who are paying not only for the politicians but for the armies of apparatchik-advisors wholly unknown at the time of Menzies and Fraser, the vast numbers of bureaucrats now paid at imagined private sector rates, the brigades of consultants and now, an emerging class of crony capitalists created by substituting political patronage for the essence of the free enterprise system, risk.

Thus an increasingly vast part of the economy, supposedly free enterprise, is simulating that of the banana republic Mr Shorten wishes to force onto a reluctant nation.

This once again presages a descent into, if not the Venezuela, the Argentina of the South Seas. This can only be reversed by fundamental reforms to the governance of this country.

Load more