The treatment of carried-forward losses in an SMSF has been clarified by a recent court decision, writes Michael Hallinan.
What is Payne’s case all about?
Payne’s case confirms a net exempt loss, that is, excess of allowable deductions relating to exempt income over exempt income, cannot be carried forward to reduce the amount of net exempt income of a subsequent financial year.
This case turned upon the correct determination of the net exempt income of an SMSF. The Payne Superannuation Fund during the 2009, 2010 and 2011 tax years was in pension phase. Consequently the fund claimed a deduction for its exempt current pension income under both the segregated method and the unsegregated method. After an ATO audit, the expenses claimed in the original assessments in respect of the exempt income and assessable income of the fund were adjusted, having the effect of reducing the carried-forward tax loss arising in the 2009 financial year and subsequently affecting the calculation of the taxable income for the 2010 and 2011 financial years.
The fund objected to the amended tax assessment and, after the objection was declined, the objection decision was referred to the Administrative Appeals Tribunal (AAT). The objection decision was considered by the AAT purely on the basis of the ‘papers’, as there was no controversy between the parties as to factual matters. The issue before the tribunal related solely to the correct interpretation of the determination of net exempt income and whether the excess of exempt losses over exempt income, that is a net exempt loss, could be carried forward to the next financial year and thereby reduce the net exempt income of the following financial year, which, in turn, would affect the amount of the tax loss that could be applied in that financial year.
The AAT affirmed the objection decision of the ATO. The tribunal held the ATO had correctly interpreted and applied the provisions of section 36-20(1) of the Income Tax Assessment Act 1997 (ITAA) and its interpretation was consistent with the correct interpretation of section 36-10 and section 36-15 of the ITAA.
The issue in Payne’s case can be illustrated in the following example using illustrative figures only.
Example 1: The MyUber SMSF
In year one, the MyUber SMSF incurred a tax loss of $16,000 and a net exempt loss of $4000.
In year two, the MyUber SMSF had net assessable income (before tax losses) of $72,000 and net exempt income of $9000.
Applying the reasoning of the taxpayer in Payne’s case, the taxation position of the MyUber SMSF in year two should be a taxable income of $61,000. This is derived by first reducing the year two net exempt income ($9000) by the excess net exempt loss ($4000), thereby producing a net figure of $5000. Second, the tax loss from year one is first applied against the now reduced net exempt income ($5000), reducing the tax loss from $16,000 to $11,000. Lastly, the reduced tax loss of $11,000 is then applied to the net assessable income of $72,000, giving a taxable income of $61,000.
According to the ATO, the position of the MyUber SMSF in year two should be a taxable income of $65,000. The net exempt loss of year one is not applied to the net exempt income of $9000. The tax loss of $16,000 is first applied against the $9000 – reducing it to $7000. Secondly, the now reduced tax loss of $7000 is then applied to the net assessable income of $72,000. The resulting figure is $65,000, which is the taxable income of the SMSF.
The difference between the two positions is the net exempt loss from year one, of $4000, is not applied against the net exempt income of year two. Consequently, the full amount of the net exempt income of year two applies to reduce the tax loss before it can be applied to the net assessable income of year two.
The outcome of Payne’s case is simply that net exempt losses are not carried forward. Net exempt losses simply have no impact on a later year’s taxable income.
Payne’s case has, however, highlighted the complex interaction between assessable income and exempt income of SMSFs and capital losses, exempt capital losses, tax losses and net exempt losses. The following sections explain this complex interaction.
Tax losses
Section 36-10 of the ITAA determines whether an SMSF has a tax loss in respect of a financial year and the amount of that tax loss.
If the SMSF has no exempt income in respect of the financial year, then the tax loss for that financial year will be equal to:
tax loss = allowable deductions – assessable income.
If the SMSF has exempt income in respect of the financial year, then the tax loss for that financial year will be equal to:
tax loss = allowable deductions – assessable income – net exempt income.
The impact of net exempt income is to reduce the amount of the tax loss that otherwise would have applied.
The tax loss is a revenue tax loss as non-exempt capital losses can only be offset against taxable capital gains with the net position (net capital gain) included in the assessable income of the SMSF for that financial year.
Whether a tax loss can be carried forward and applied to reduce the net assessable income of a subsequent financial year is determined by section 36-15 of the ITAA. This section addresses two situations: where the later financial year has no net exempt income and where the later financial year has net exempt income.
Section 36-20 of the ITAA specifies when an SMSF will have net exempt income in respect of a financial year. In broad terms, if the exempt income of the SMSF for that financial year exceeds the losses and outgoings incurred in deriving the exempt income, then the SMSF will have net exempt income and the amount of the net exempt income is the excess. The provision expressly excludes capital losses and outgoings.
The provision also permits any foreign taxes paid in respect of the exempt income to reduce the amount of the net exempt income.
In Payne’s case, the taxpayer argued the expression “losses and outgoings … incurred in deriving that exempt income” when used in section 36-20 covered not only expenses incurred in the current year, but also net exempt losses of a previous financial year. Consequently, according to the taxpayer, the prior year net exempt loss could be applied in the current financial year to reduce the excess of exempt income over exempt expenses. The AAT held the expression simply mirrored the language used in the general deduction provision of section 8(1) (and the corresponding provision of section 52(1) of the ITAA 1936). As prior year losses are not deductible under section 8(1), then the language when used in section 36-20(1) does not extend to cover prior year net exempt losses.
As section 36-20 expressly refers to the ‘amount’ of exempt income that ‘exceeds’ the relevant losses and outgoings, the term ‘net exempt income’ can only be a positive amount. Hence section 36-15 only contemplates two situations: where there is net exempt income in respect of a financial year and where there is not.
Questions from Payne’s case
Can allowable deductions be offset against assessable contributions?
Assessable contributions are included in the assessable income of the SMSF. Any loss or outgoing that is deductible can be applied to reduce the assessable income of the fund: there is no segmentation of assessable income into ‘assessable contributions’ and ‘investment income and net capital gains’. Consequently, allowable deductions are able to be offset against the total assessable income.
For example, if an SMSF had $16,000 in assessable contributions, investment income of $8000 and allowable deductions of $10,000, then the taxable income of the SMSF would be $14,000. Effectively the allowable deductions have reduced the assessable contributions from $16,000 to $14,000.
If the allowable deductions had been $18,000, instead of $10,000, then the taxable income of the SMSF would be $6000. Hence the allowable deductions have sheltered $10,000 of the allowable deductions.
Can tax losses be offset against assessable contributions?
In short, yes. Any tax loss will be first offset against the net exempt income of the current year and the balance of the tax loss is then applied against the net assessable income.
If the net assessable income includes assessable contributions, the tax loss (after first being reduced by the net exempt income if any) can be used to shelter assessable contributions.
If an SMSF had a very large tax loss, possibly from an anti-detriment payment, from an earlier tax year, the tax loss (after reduction by the net exempt income, if any) will be offset against the net assessable income of the current year and therefore necessarily offset against assessable contributions.
How can capital losses be carried forward if the fund is in pension phase?
If the SMSF is completely in pension phase for the entire financial year, or the capital loss arose from a segregated current pension asset, then the capital loss is disregarded.
If the SMSF is not completely in pension phase for the entire financial year (because it has one or more accumulation accounts) and if the asset that generated the capital loss has not been designated as a segregated current pension asset, then the capital loss is not disregarded. This means the SMSF will need an actuarial certificate and its exempt current pension income percentage will be less than 100 per cent. However, if the accumulation account is relatively small compared to the value of the fund, the exempt current pension income percentage may be very close to 100 per cent.
If there are immaterial or no assessable capital gains in the financial year, there will be no net taxable capital gain for the financial year. Consequently, the capital loss, as it is not an exempt capital loss, will be carried forward and be available to be offset against taxable capital gains, if any, of subsequent financial years.
How do tax losses arise in SMSFs?
As investment losses will generally be on the capital account, the most likely source of significant tax losses in an SMSF will arise from the payment of an anti-detriment payment (giving rise to a grossed up tax deduction under section 295-485 of the ITAA) or from the deduction available in respect of the future service portion of death or disability benefits under section 295-470 of the ITAA.
Can tax losses incurred by one generation of SMSF members be used by a subsequent generation of members?
In short, yes, as the tax loss rules of schedule 2F of the ITAA 1936 do not apply to complying superannuation funds. Consequently, an SMSF that pays an anti-detriment payment in respect of SMSF member Bill, thereby giving rise to a substantial tax deduction, can apply that tax deduction to reduce the tax otherwise payable on the assessable contributions of other members.
If the substantial tax deduction gives rise to a tax loss, then that tax loss can (after being reduced by the net exempt income of the recoupment year) be applied to shelter the assessable contributions of Bill’s children or even grandchildren that are made only after Bill’s death. The children or grandchildren need not even have been members of the SMSF at the time Bill died.
Could part IVA of the ITAA 1936 apply to such a strategy? Most likely not, given the decision of the High Court in the Commercial Nominees case [2001] HCA 33.