Taxing issues for superannuation funds

Recent legislative changes combined with the Federal Budget have served to change the taxation landscape for major superannuation funds, writes specialist lawyer Noel Davis.

With effect from July 1, 2010 (or July 1, 2009, if trustees so elect), a new regime to tax capital gains applies to large super entities (superannuation funds and pooled superannuation trusts that have assets of at least $100 million).

It also applies to large managed investment schemes (such as equity, property and cash trusts in which superannuation funds invest) that have assets of at least $100 million.

It has the effect of the income tax rate of 15 per cent applying to gains on some investments rather than the capital gains tax (CGT) rate of 10 per cent that often applies to gains on investments held for at least a year.

The Act

The legislation, the Tax Laws Amendment (Taxation of Financial Arrangements) Act 2009 (known as TOFA), which was passed earlier this year, has been a long time coming. It was first announced by the previous Government in 1999.

It is mandatory in its operation and it alters the tax regime that applies to financial institutions, including large super entities and unit trusts, in relation to ‘financial arrangement’ assets.

Its effect is that for some investments, instead of CGT applying when they are sold, the gains that are determined to exist, in accordance with the method that applies under the Act, are required to be treated as assessable income each year and taxed as such, and capital losses on such investments are deductible from assessable income.

An amount that is treated as income under the Act is not taxable as a capital gain (subsection 118-27 and 230-20 of the Tax Act 1997). That is why the reduced CGT tax rate of 10 per cent will not apply to gains on some ‘financial arrangement’ assets.

This Act, therefore, brings about a significant change in the way large super entities are taxed on some investment gains and the amount of tax that they will pay.

Senate Economics Committee

The bill for this Act was referred to the Senate Economics Committee on December 4, 2008, and was subsequently considered by it.

Ten submissions were made to it, but none were from superannuation industry representative bodies (other than the Investment and Financial Services Association) or superannuation funds.

There have been earlier drafts of the bill that have been the subject of discussions and submissions.

It appears, however, that the Act, in its final form, has largely escaped the notice of the superannuation industry.

The committee, in its report of February 26, 2009, said the bill had been described as one of the most complicated and significant pieces of fiscal law in the past two decades.

I agree that it is complex and its effect needs to be carefully considered by trustees and their advisers.

The committee recommended that the bill be passed, and it was on March 11, 2009.

How the Act works

The broad aim of the Act is to align the calculation of profit with accounting standards.

It treats gains and losses on ‘financial arrangements’ as revenue (section 230-15), rather than capital, with the consequence that gains on such arrangements are assessable income and losses are deductible.

For this purpose, a ‘financial arrangement’ is very broadly defined as existing if the fund or trust has a legal or equitable right to receive a monetary financial benefit (section 230-45).

Because of section 230-50, equity interests such as shares and units in unit trusts are also ‘financial arrangement’ assets, as discussed below.

There is a difference between the limited investments of large super entities that come within the regime and the wider range of investments of unit trusts that come within it.

However, because of section 97 of the Tax Act 1936, a large super entity that holds units in a unit trust is required to treat its share of the assessable income of the unit trust as its own assessable income.

The large super entity, therefore, pays the tax on its share of the assessable income of the unit trust, rather than the unit trust itself.

For that reason, it is highly relevant to a large super entity that invests in unit trusts (as many do) what is treated as the income of each unit trust under TOFA, rather than a capital gain.

For large super entities, because of section 295.85 of the Tax Act 1997, not all of their ‘financial arrangement’ assets are taxed under TOFA. Investments made directly by them that are subject to TOFA and taxed accordingly are limited to currency exchange fluctuations, loans, bonds, debentures, certificates of entitlement, bills of exchange, promissory notes and other securities.

Gains on these direct investments are required to be treated as income rather than capital gains, and losses are deductible.

However, where a large super entity invests in a share, property, cash or other unit trust with assets of at least $100 million, the ‘financial arrangement’ assets of the unit trust can include shares, units in other unit trusts, loans, bonds, promissory notes, debentures and derivatives.

Large super entities will, under TOFA, pay income tax on their share of the ‘financial arrangement’ asset gains in the unit trust, rather than CGT.

The reason company shares and units in other unit trusts can constitute ‘financial arrangement’ assets in a large unit trust is because, as stated in paragraphs 45 and 194 of the explanatory memorandum (EM) of the TOFA Bill, equity interests (as defined in the Tax Act 1997) are ‘financial arrangements’ for the purposes of the Act. What is stated in the EM reflects what is said in section 230-50 of TOFA.

For this purpose, an equity interest has the meaning given by subdivision 974-C (for a company) and section 823-930 (for a trust) of the Tax Act 1997.

Under section 974-75, an equity interest exists in a company if it is an interest as a member or stockholder of the company and, under section 823-930, an equity interest exists for a trust if it is an interest as a beneficiary of the trust.

It is important to note, however, that whether or not equity interests held by a large unit trust are ‘financial arrangement’ assets depends on the election made by the unit trust trustee.

Elections are discussed below. If, because of the election the trustee of the unit trust makes, investments in shares and units are not ‘financial arrangement’ assets of the unit trust, the CGT regime will continue to apply to gains or losses on them.

But, if they are ‘financial arrangement’ assets, the gains will be assessable income of the large super entities that invest in the unit trust and the losses will be deductible.

The trustee’s elections

While TOFA applies to ‘financial arrangement’ assets acquired after June 30, 2010, trustees of large super entities and large unit trusts can elect that it also apply to assets held on July 1, 2009.

If trustees regard the new arrangement as being beneficial to their beneficiaries, they could elect that it applies from the earlier date.

The Act also makes provision for the trustee to make an election as to which of several different methods is to apply in determining the gain or loss, including an accruals or realisation method, a fair value method or a reliance on the financial reports method (section 230-40).

An election, once made, is irrevocable, but it can cease to apply in certain circumstances.

The accruals method can be elected if there is a sufficiently certain gain or loss that can be calculated with reasonable accuracy at the time the investment is made (section 230-100).

If the accruals method does not apply, and the realisation method is elected, the gain or loss occurs at the time at which the last of the financial benefits is provided to the fund or trust (section 230-180), which would usually be the date of disposal of the investment.

A fair value election can be made if the fund or trust’s financial report is prepared and audited in accordance with the accounting standards (section 230-210). If this election is made, the gains or losses each year are determined in accordance with the movements in the fair value of the ‘financial arrangement’ investments.

Another election that can be made under subdivision 230-F is to rely on the fund or trust’s financial report. Such an election can be made if the accounts are prepared in accordance with accounting standards and audited in accordance with the auditing standards (section 230-410).

It results in gains or losses on ‘financial arrangement’ assets at their fair value being taxable under TOFA.

If the trustee does not make one of the elections available to it, the tax treatment defaults to either the accruals or the realisation method.

Trustees of unit trusts should note that equity ‘financial arrangement’ assets, such as company shares and units in other unit trusts, only become ‘financial arrangement’ assets of the trust if either the fair value or the reliance on the financial reports election is made (paragraph 1116 of the EM and subsection 230-40(4)(e), 230-270(1) and 230-330(1)).

The effect on unit holders, therefore, needs to be carefully considered in deciding whether to make either of those elections.

Large super entities will, therefore, be put in the hands of the unit trusts in which they invest as to what tax treatment applies to equity “financial arrangements” such as shares and units.

Whether gains on those investments are taxable as income in the superannuation funds will be determined by the elections that the trustees of the unit trusts make.

That may affect decisions by large super entities as to which unit trusts they invest in.

Of course, if the unit trust has assets of less than $100 million, TOFA will not apply to it.

Managed investment trusts and the Budget announcement

Since TOFA was passed, it was announced in the 2009-10 Federal Budget that: “The Government will allow Australian managed investment trusts (MITs), except those that are taxed like companies, to make an irrevocable election to apply the CGT regime as the primary code for taxing certain disposals of assets, with effect from the 2008-09 income year ...

“This measure will ensure the taxation treatment of disposals of assets (primarily shares in a company, units in a unit trust and real property investments) by MITs is consistent with the taxation treatment of disposals of similar investments by complying superannuation funds.”

The combined effect of TOFA and the subsequent Budget announcement appears to be that MITs that come within the announcement (and which do not elect for TOFA to apply from July 1, 2009) will, for the 2008-09 and 2009-10 income years, be taxed under the CGT regime.

For 2010-11 onwards, MITs to which TOFA applies will be taxed under the CGT regime for their ‘non-financial arrangement’ investments, but gains and losses on their ‘financial arrangement’ investments will be taxed under TOFA.

The final outcome of this announcement will not be known until the legislation to give effect to it is enacted.

Conclusion

What I have said above is, of course, just a short summary of the effect of TOFA, as I understand it.

Because of the implications of the Act for each large super entity and managed investment scheme, trustees should obtain advice on the impact it has on the investments of their particular fund or trust and on how they should exercise the elections provided for in the Act.

Noel Davis is a specialist financial services lawyer.