SMSFs need to revise their management of revenue losses in the wake of the ATO’s renewed focus on the issue, writes Daniel Butler.
A recent decision, Re Trustee for the Payne Superannuation Fund and FCT  AATA 58, examines how the ATO is examining whether SMSFs are appropriately carrying forward tax losses and apportioning expenses when they are partly in pension mode. Prior to analysing the implications of this decision, we will first examine a general overview of how the tax rules in relation to losses in an SMSF environment operate. SMSFs, like other taxpayers, may accumulate revenue losses that can offset future assessable income.
What is a revenue tax loss?
Broadly, a revenue loss is one that is not a capital loss. For example, a revenue loss may arise where an SMSF has borrowed to invest in a rental property and the SMSF is negatively geared, that is, its expenses, particularly interest on a limited recourse borrowing arrangement (LRBA), exceed the rental and other income the SMSF derives.
How does this differ to a capital loss?
Broadly, a capital loss is one that relates to where a capital gains tax event occurs and the cost base, or reduced cost base as applicable, is greater than the consideration received.
Generally a capital loss can only offset a capital gain. However, where an SMSF is in pension mode and has adopted the segregated method, then any capital loss is disregarded; as is any capital gain on disposal of a segregated asset (section 118-320 of the Income Tax Assessment Act 1997 (ITAA 1997).
In contrast, if an SMSF is unsegregated, then any capital loss is carried forward for offset against any future net capital gain in accordance with the method statement in section102-5 of the ITAA 1997.
Are there special rules for an SMSF to carry forward a revenue loss?
An SMSF is a form of trust and trusts must generally satisfy the applicable tests in schedule 2F of the Income Tax Assessment Act 1936 (ITAA 1936) to be in a position to carry forward revenue losses.
However, an SMSF is an ‘excepted trust’ as an excepted trust in section 272-100(b) includes a complying superannuation fund. A fund is a complying superannuation fund if it satisfies the criteria in section 45 of the Superannuation Industry (Supervision) Act. The trust loss measures in Schedule 2F of the ITAA 1936 therefore do not apply to a complying SMSF, which is a trust that is an excepted trust.
Accordingly, an SMSF that has revenue losses from its own activities will generally not be required to make a family trust election (FTE). In comparison, a discretionary family trust typically has to make an FTE to be able to carry forward a revenue loss. A unit trust that is not a fixed trust will also generally be required to make an election.
Moreover, where an SMSF holds investments in a unit trust, this may invoke the requirement for the SMSF to make an FTE or, in some circumstances, an interposed entity election (IEE). This is required, for instance, where the unit trust is not a fixed trust.
A fixed trust includes unit trusts that do not have any non-fixed or discretionary entitlements, that is, beneficiaries have a vested and indefeasible interest. A fixed trust is defined in section 272-65 of the ITAA 1936 as follows: “A trust is a fixed trust if persons have fixed entitlements to all of the income and capital of the trust.”
The expression fixed entitlement in section 272-5(1) of the ITAA 1936 is defined to mean: “If, under a trust instrument, a beneficiary has a vested and indefeasible interest in a share of income of the trust that the trust derives from time to time, or of the capital of the trust, the beneficiary has a fixed entitlement to that share of the income or capital.”
The concept of fixed entitlements, as defined in section 272-5(1) of the ITAA 1936, was considered in Colonial First State Investments Limited v FCT  FCA 16. There, a special resolution (that is, 75 per cent) was able to vary the terms of the trust. Accordingly it was held that “members could vote to terminate the present right to a share of income and capital” and thus there were not fixed entitlements as defined in section 272-5(1).
Unit trust deeds are not a generic product and not many unit trusts satisfy this test of fixed trust. Thus, if an SMSF has invested in a unit trust and that unit trust has revenue losses, then the ability for that unit trust to use any current financial year (FY) or carried-forward tax losses will, in the first instance, depend on whether it is fixed. In many cases, due to poorly drafted unit trust deeds, the trust will not be fixed.
A fixed trust cannot deduct a revenue loss unless it satisfies the 50 per cent stake test (sub-division 266-40) or the non-fixed trust stake test (section 266-45).
If the particular unit trust in question is not a fixed trust, that is, it is a non-fixed trust, then the following tests must generally be satisfied for that non-fixed unit trust to carry forward its tax (revenue) losses:
- A continuity of beneficial ownership test (looking at changes in actual and potential beneficiaries): sub-division 269-C of the ITAA 1936;
- A pattern of distributions test (looking at consistency in distribution of trust property to beneficiaries prior to the loss year): sub-division 269-D of the ITAA 1936;
- A continuity of control test (looking at changes in trustees and appointers): sub-division 269-E of the ITAA 1936; and
- An income injection test (looking at the relationship between income sheltered by losses and arrangements entered into or consideration provided by persons which differ from that which would have occurred had the persons been dealing at arm’s length, that is, without the benefit of the trust loss): division 270 of the ITAA 1936.
Broadly, it is generally difficult for a non-fixed trust to carry forward its revenue losses unless the appropriate elections are made (for example, an FTE or IEE).
Typically if the SMSF holding units in the non-fixed unit trust makes an FTE, the unit trust would make an IEE. There are a number of ATO interpretive decisions (ID) that relate to this area, such as ATO ID 2002/676, 2002/746W, 2002/748W, 2002/749W and 2002/750W. The last four of these have been withdrawn on the basis they merely restate what the law is, but they are still of assistance in gaining an understanding of how the law operates.
Is the test for non-arm’s-length income different?
It should also be noted the definition of fixed trust for revenue losses in schedule 2F of the ITAA 1936 differs from the ATO’s practice in relation to that term in section 295-550 of the ITAA 1997. This practice appeared to be accepted by the ATO in Re MH Ghali Superannuation Fund and FCT  AATA 527 and the paragraphs below, especially at 102, extracted from TR 2006/7.
Broadly, the paragraphs below provide an insight into the ATO’s practice in relation to non-arm’s-length income (NALI), which distinguishes between a loose fixed entitlement compared to a discretionary entitlement for NALI.
Trust distributions not arising from a fixed entitlement
101. If a complying superannuation fund … derives income from a trust by way of the trustee or any other person exercising a discretion, the income distributed will be special income under section 273(6).
Trust distributions arising from a fixed entitlement
102. A trust distribution to a complying superannuation fund … will fall within section 273(7) rather than section 273(6) if the entity’s entitlement to the distribution does not depend upon the exercise of the trustee’s or any other person’s discretion.
103. A trust distribution arising from a fixed entitlement will only be special income if three conditions are met:
- the entity must have acquired the fixed entitlement under an arrangement or the income must have been derived under an arrangement;
- some or all of the parties to the arrangement must not have been dealing with each other at arm’s length; and
- the amount of the distribution must be greater than the amount of income that might have been expected if the parties had been dealing with each other at arm’s length.
Careful management of the treatment of revenue losses is therefore required where an SMSF owns units in a unit trust.
As discussed above, where the revenue losses arise directly in the SMSF (that is, there is no investment by the SMSF into a unit trust), then the SMSF can carry forward its losses as it is an excepted trust under schedule 2F of the ITAA 1936.
Thus, where an SMSF is in accumulation mode, division 36 of the ITAA 1997 sets out how to calculate a loss, how to deduct a loss and how to calculate net exempt income. The main provisions applicable to an SMSF in division 36 are summarised below. These provisions set out a framework of understanding how losses are treated.
How to calculate a tax loss
Section 36-10 of the ITAA 1997 sets out how to calculate a tax loss for an income year as follows:
- Add up the amounts you can deduct for an income year (except tax losses for earlier income years).
- Subtract your total assessable income.
- If you derived exempt income, also subtract your net exempt income (worked out under section 36-20).
- Any amount remaining is your tax loss for the income year, which is called a loss year.
How to deduct tax losses
Section 36-15 of the ITAA 1997 sets out how to deduct tax losses (of entities other than corporate tax entities). Your tax loss for a loss year is deducted in a later income year as follows if you are not a corporate tax entity at any time during the later income year.
If you have no net exempt income:
- If your total assessable income for the later income year exceeds your total deductions (other than tax losses), you deduct the tax loss from that excess.
If you have net exempt income:
- If you have net exempt income for the later income year and your total assessable income (if any) for the later income year exceeds your total deductions (except tax losses), you deduct the tax loss:
- firstly, from your net exempt income; and
- secondly, from the part of your total assessable income that exceeds those deductions.
However, if you have net exempt income for the later income year and those deductions exceed your total assessable income, then:
- subtract that excess from your net exempt income; and
- deduct the tax loss from any net exempt income that remains.
If you have two or more tax losses, you deduct them in the order in which you incurred them.
How to calculate net exempt income
Section 36-20(1) of the ITAA 1997 sets out how to calculate net exempt income. If the taxpayer is an Australian resident, your net exempt income is the amount by which your total exempt income from all sources exceeds the total of: the losses and outgoings (except capital losses and outgoings) you incurred in deriving that exempt income; and any taxes payable outside Australia on that exempt income.
SMSF in pension mode with tax losses
When an SMSF derives exempt income (that is, eligible concession pension income (ECPI)) when it is in pension mode, there is a need to manage the fund’s tax position as it may also have revenue losses that the fund can carry forward. This is because, broadly, revenue losses are reduced by exempt income or more specifically by net exempt income. This requires an SMSF to carefully allocate expenses between both assessable and exempt income prior to ascertaining any carry-forward revenue loss. This can easily be overlooked as the ATO has undertaken audit activity on SMSFs not correctly calculating their exempt income and reducing expense claims to the extent that the fund derives exempt income, and the like.
In Payne’s case, the SMSF trustee claimed deductions for ECPI. The ATO audited the fund’s tax returns in respect of claims for tax losses and amended assessments were issued apportioning expenses claimed by the fund between the assessable and exempt income, resulting in the amount of net exempt income and the carried-forward tax losses for FY 2010 and FY 2011 being adjusted.
The tribunal in Payne’s decision noted that:
- Under section 36-10 of the ITAA 1997, a tax loss can be expressed as the following formula:
- Tax loss = (allowable deductions – assessable income) – net exempt income
- A carried-forward tax loss is deducted in later income years in accordance with the rules in section 36-15 of the ITAA 1997.
For an Australian resident, the term net exempt income is defined in section 36-20. It is used in determining whether a tax loss exists and the manner in which that tax loss is required to be deducted. For a resident taxpayer (such as an SMSF) net exempt income for an FY is the amount by which the total exempt income from all sources for that FY exceeds the total of the losses and outgoings (except capital losses and outgoings) incurred in deriving that exempt income, and any taxes payable outside Australia on that exempt income.
Specifically, section 36-20(1) is applied to SMSFs in the same way as it is applied to other taxpaying entities, but having regard to provisions of the ITAA 1997 that apply to superannuation funds.
When section 36-20(1) speaks of losses and outgoings incurred in deriving that exempt income, the section allows a deduction for a loss or outgoing to the extent that it is incurred in deriving that exempt income in that FY.
There are no provisions of the tax law that provide that where losses and outgoings in relation to exempt income exceed exempt income, the excess can be applied to reduce net exempt income in a future FY. While there are specific provisions relating to earlier FY tax losses related to assessable income, there is no corresponding provision in relation to exempt income.
SMSFs need to carefully manage tax losses
The Payne decision is a timely reminder that SMSFs in pension mode need to carefully ensure they do not over claim deductions and ensure expenses are accurately and appropriately allocated between assessable and exempt income. Tax losses must be reduced by net exempt income and any remaining tax loss can be carried forward to a subsequent FY.
Naturally, all else being equal, a tax loss may be of little value if the fund derives sufficient net exempt income that will reduce this loss. This may be the case, for instance, after an anti-detriment deduction is claimed and a surviving spouse is left as the sole member of the fund in pension mode. Fortunately, there are a number of planning strategies to ameliorate this type of problem.