The SMSF income incurs a tax at a favourable rate of 15%. So, what is the process of maximizing tax efficiency in your SMSF? There is a catch – your fund needs to be a complying fund, which means it adheres to all the laws and regulations governing SMSFs. If, for some reason, your fund does not comply, it will receive the highest marginal tax rate.
In the world of SMSF taxes, the usual suspects for assessable income in complying funds are assessable contributions, net capital gains, interest, dividends, and rental income. These are the vital players you will want to keep an eye on.
Assessable Contributions
Assessable contributions in a complying SMSF are specific contributions. They’re part of the taxable income for the fund. These contributions have a tax rate of 15% (or 47% for non-complying SMSFs). They include:
- Employer contributions. This also covers contributions from salary sacrifice arrangements.
- Personal contributions. These are indicated by a member for tax deduction.
- Contributions made by someone other than the member. There are exceptions like spouse contributions and government co-contributions.
If a member hasn’t provided their TFN, there are a few things to note. You’ll pay additional tax on their mandated employer contributions. Also, you can’t accept other payments. The additional tax rates are 34% for complying SMSFs and 2% for non-complying SMSFs.
However, if the member later provides their TFN, you might be able to claim back the additional tax. This can be done as a no-TFN tax offset in your SMSF annual return. Remember, you can only claim this offset within three years from the end of the financial year in which the contributions with additional tax were made.
If you debit the additional tax from your member account and later claim the tax offset, re-credit the money to their account. This ensures everything balances out in the end.
Tax Exemptions in the Retirement Phase
Usually, a compliant self-managed super fund (SMSF) has a favorable tax rate of 15%.
However, when an SMSF starts providing superannuation income streams (often called pensions) in retirement phase, it gets more tax concessions.
The income generated by SMSF investments is tax-exempt if those assets support income streams in retirement phase. This income is known as exempt current pension income (ECPI).
You can claim ECPI in your SMSF’s annual return once it starts paying one or more retirement phase income streams. Remember, your SMSF doesn’t automatically qualify for ECPI. There are specific steps you must follow to be eligible to claim it.
Capital Gains
Regarding capital gains, note that your SMSF assessable income will include any net capital gains. This is unless the asset falls under a segregated current pension asset category. Complying SMSFs are eligible for a capital gains tax (CGT) discount of one-third if they have held the relevant asset for at least 12 months.
We calculate a net capital gain by taking the total capital gain for the year. Then, we subtract total capital losses for that year along with any unapplied capital losses from earlier years. Additionally, you would subtract the CGT discount and any other applicable concessions.
For capital losses, like those from the sale of commercial premises, we do not consider them as allowable deductions. You can only use them to offset against capital gains. If in a given financial year, capital losses exceed capital gains, you can carry them forward to offset against future capital gains.
Now, let us talk about transitional CGT relief. It is a temporary measure available to trustees of superannuation funds, including SMSFs. This applies when adjusting asset allocations to comply with the transfer balance cap and transition-to-retirement income stream (TRIS) reforms that began on 1 July 2017.
Individuals may have needed to adjust the amounts supporting their superannuation income streams to adhere to the transfer balance cap reforms. They might have achieved this by transferring value from the retirement phase to the accumulation phase. Also, for those with a TRIS not in the retirement phase, earnings on assets supporting these streams became taxable from 1 July 2017.
The relief ensures that certain assets supporting superannuation income streams in the retirement phase before 1 July 2017 can still receive a tax exemption on accrued but unrealized capital gains.
When applying for CGT relief, the cost base of an asset is reset to its market value. This is determined as per the Valuation guidelines for self-managed super funds on the date the relief is applied. This process also allows you to defer a capital gain that arises when resetting the cost base for assets where you use the proportionate method.
Non-arm’s Length Income
SMSFs must conduct transactions on an arms-length basis. This means that buying and selling prices of fund assets should accurately reflect their market value. The income generated from assets in your fund should align with the correct market rate of return.
Any income falling under the category of non-arm’s length income is subject to taxation at the highest marginal rate.
In broad terms, income is considered NALI for a complying SMSF if it meets two criteria:
1. It derives from a scheme in which the parties involved are not engaging in arm’s-length dealings.
2. It exceeds what the SMSF might have reasonably expected to earn if the parties’ conducted transactions at arm’s length.
Now, let us look at specific types of NALI income. Income received by an SMSF as a beneficiary of a discretionary trust falls under this category. Similarly, dividends paid to an SMSF by a private company are NALI unless the dividend aligns with arm’s-length dealings.
Furthermore, income received by an SMSF as a beneficiary of a trust through holding a fixed entitlement to the income of the trust is NALI under two conditions:
1. The SMSF acquired the entitlement under a scheme, or the income derives under a scheme not following arm’s-length dealings.
2. The income surpasses what the SMSF would have reasonably expected to earn if you maintain arm’s-length dealings.
From 1 July 2018, the definition of NALI broadened. It now includes income derived by an SMSF from a scheme where you do not follow arm’s-length dealings. If the fund’s expenses in deriving the income were lower than expected under arm’s-length dealings.
These expenses may be either of a revenue or capital nature. It is similar to how NALI income can be either statutory or ordinary. They amended the law to ensure that income derived by an SMSF in the capacity of a trust beneficiary will be considered NALI. It applies if the SMSF acquired the entitlement under a scheme not based on arm’s-length dealings and incurred expenses that were less than expected under such dealings. This change came into effect from 1 July 2018.
Deductions
A compliant SMSF can deduct certain losses or expenses from its assessable income. You can claim these deductions if they meet either of the following criteria:
1. They incurred in the process of generating assessable income.
2. They were necessary expenses for a business to make or produce such income.
However, note that losses and expenses connected to exempt current pension income are generally not eligible for deduction. It is because they incur in the process of earning exempt income. In situations where the fund has both accumulation and pension members, there might be a need to apportion the expense to determine the deductible amount for the fund. It ensures a fair allocation between the two categories of members.
