This document summarizes a session from the 2011 SMSF National Conference about what to expect when the Australian Taxation Office (ATO) audits self-managed superannuation funds (SMSFs). The ATO doubled the number of SMSF audits it conducted in 2011 and identified more funds as non-compliant. Top areas the ATO will target include loans to members or relatives, breaches of in-house asset rules, and administrative issues. The document provides examples of how the ATO determines if a loan is legitimate or an early release benefit, and when it may accept an enforceable undertaking for non-compliance issues.

1. 2011 SMSF National Conference Session 19A What to expect when the ATO comes knocking Darren Wynen 1 © Insyt Pty td 2010

2. Introduction Outline of session The latest intelligence on the ATO’s approach to auditing SMSFs Top target areas of the ATO for 2011 Other compliance issues for 2011 2 © Insyt Pty td 2010

3. Introduction ATO reviewed 5,700 funds in 2010 In 2011, number doubled to 10,800 Additional $20 million in liabilities for 2010 ATO starting to show a firmer hand in its compliance activities WARNING – New measures introduced for auditors 3 © Insyt Pty td 2010

4. Latest Intelligence 185 funds made non-complying in 2010 Seems small but up from five in 2007 and 24 funds in 2008 Number of non-compliance cases before the courts on the rise Refer to XPMX, JNVQ, and now ZDDD 4 © Insyt Pty td 2010

5. Latest Intelligence Complying fund if S.42A(1) met: Fund is ‘resident regulated super fund’; and Compliance test in S.42A(5) satisfied: No regulatory provisions contravened; or Contraventions occur but the Commissioner says fund should still be complying after considering: Taxation consequences that would arise; Seriousness of contraventions; and All other relevant circumstances 5 © Insyt Pty td 2010

6. Latest Intelligence EXAMPLE – Non-resident fund Mark is the sole member of a fund. Becomes a NZ resident from 1 July 2010. CM&C test now in NZ so fund ceased to be Aust. resident fund from 1 July 2010 Fund non-complying for 2011 Can Commissioner override? No,S.42A(5) cannot change outcome. 6 © Insyt Pty td 2010

7. Latest Intelligence First factor– taxation consequences Two tax effects: Market value of fund’s assets less undeducted contributions = assessable Fund’s taxable income taxed at 45% WARNING – Loss of pension exemption Pension exemption only applies to a ‘complying superannuation fund’ 7 © Insyt Pty td 2010

8. Latest Intelligence EXAMPLE – Non-complying fund Sam is a member of the Tricky SMSF All fund assets support the payment of a pension to Sam Fund deemed non-complying in 2011 Does pension exemption continue to apply? No, exemption only applies to a complying fund 8 © Insyt Pty td 2010

9. Latest Intelligence EXAMPLE – Non-complying fund How much tax is payable? Assumptions: Assets = $800,000 UC = $400,000 Income in 2011 of $56,000 One-off adjustment = $400,000 x 45% = $180,000 Tax on fund income = $56,000 x 45% = $25,200 9 © Insyt Pty td 2010

10. Latest Intelligence Second factor – seriousness Behaviour Proportion of assets affected Financial exposure of assets Number of contraventions Nature of the contravention 10 © Insyt Pty td 2010

11. Latest Intelligence Third factor – all other circumstances Action taken by trustee Trustee level of skill and knowledge Compliance history Trustee’s personal circumstances 11 © Insyt Pty td 2010

12. Latest Intelligence Other options of ATO to deal with contraventions Enforceable undertaking Informal arrangement Disqualification Suspending/removing trustee Freezing fund assets Seeking penalties No action 12 © Insyt Pty td 2010

13. Latest Intelligence When will the ATO accept an enforceable undertaking? Can the contravention be rectified? Timeframe Past behaviour of the trustee Nature and seriousness of the contravention Criminal consequences arise? 13 © Insyt Pty td 2010

14. Latest Intelligence CASE STUDY 1 – Enforceable undertaking Gabriella and Michael are members and trustees of Big Red Car SMSF 1 June 2010 fund lends Michael $30,000 On 8 September 2010 the fund informs the ATO of the contraventions and that: Michael repaying $1,000 per month; and Loan to be repaid by 1 December ATO rejected this timeframe 14 © Insyt Pty td 2010

15. Latest Intelligence CASE STUDY 1 continued Would ATO accept payment by mid-October? Yes, because: Undertaking is appropriate; and Terms are appropriate. Comment ATO less likely to accept undertaking if: Loan was significant or trustees could not repay; or Early access benefit. 15 © Insyt Pty td 2010

16. Latest Intelligence CASE STUDY 2 – ZDDD Kevin and Janine are members and trustees of the KJ SMSF with $420,000 KJ SMSF invested $420,000 in a pre-Aug 99 unit trust Unit Trust buys a rental property for $320,000 In 2004, loans made the Unit Trust to other related parties 16 © Insyt Pty td 2010

17. Latest Intelligence CASE STUDY 2 continued $320,000 to buy rental property Unit Trust $50,000 loan to Kevin $50,000 loan to family trust $420,000 KJ SMSF 17 © Insyt Pty td 2010

18. Latest Intelligence CASE STUDY 2 continued Kevin and Janine get deeper into financial difficulties During 2005, unit trust sells property, with proceeds being used to make additional loans Loans are undocumented, unsecured and interest-free At 30 June 2009, loans still outstanding 18 © Insyt Pty td 2010

19. Latest Intelligence CASE STUDY 2 continued What breaches have occurred? Breach of sole purpose test – S.62(1) Financial assistance to Kevin – S.65(1)(b) Contravention of S.109(1) Is the Commissioner likely to accept an enforceable undertaking? No, due to seriousness of contraventions Similar to ZDDD 19 © Insyt Pty td 2010

20. ATO Target Areas Top ATO targets for 2011 Loans to members or relatives Breaches of the in-house asset rules Administrative breaches Assets not in the fund’s name Contravention of the operating standards Breach of sole purpose test 20 © Insyt Pty td 2010

21. ATO Target Areas Loans to members or relatives Accounts for 22% of reported breaches Flow-on breach of in-house asset rules accounts for 16% of breaches 25% of cases, amount withdrawn is not a loan but an early release benefit Factors the ATO looks for to determine if amount is a loan – SMSFR 2009/4 21 © Insyt Pty td 2010

22. ATO Target Areas CASE STUDY – No loan agreement Mary and David are members and trustees of the Laundry SMSF Fund advances a loan (3%) of fund assets to Susan, a relative Verbal agreement to repay within 3 years Repayments already being made 22 © Insyt Pty td 2010

23. ATO Target Areas CASE STUDY continued Would the ATO say this is a loan? Yes, for the following reasons: Documentary evidence Payment is shown as a loan and interest accrued Terms can be detailed (although verbal) Repayments made on time What are the ramifications? Financial assistance, in-house asset Consider enforceable undertaking 23 © Insyt Pty td 2010

24. ATO Target Areas Contravention of in-house asset rules Follow-up of 900 ACRs (400 in 2010) Many breaches result from loans Contraventions can occur from: Breach of 5% cap at year-end; Acquisition of new in-house asset over 5% Commissioner has a range of options to deal with contraventions 24 © Insyt Pty td 2010

25. ATO Target Areas Contravention of in-house asset rules Commissioner can also make a determination under S.71(1)(e) – PS LA 2009/8 S.71(1)(e) only applies if ‘unusual or out of the ordinary’, which does not include: Fluctuations in economic conditions; Trustee unaware of requirements; Significant costs to unwind; or Fund does not satisfy non-geared trust exception. 25 © Insyt Pty td 2010

26. ATO Target Areas EXAMPLE – Event in 13.22D occur Jack and Jill members and trustees of the Sail SMSF The fund invests in a non-geared unit trust, and satisfies Reg 13.22C On 10 December 2010, the trust buys shares in BHP Ltd 26 © Insyt Pty td 2010

27. ATO Target Areas EXAMPLE continued Does the purchase of BHP cause the fund’s investment to be an in-house asset? Yes, event in 13.22D(1)(b) occurs Does this contravene the in-house asset rules Yes, a contravention of S.83 occurs as the value of the units represents 60% of the fund’s assets If 5% cap exceeded at 30 June 2011, would need to prepare a plan to dispose of excess 27 © Insyt Pty td 2010

28. Other issues Compliance issues for return Misreporting on return Exempt current pension income Non-lodgment of returns Excess contributions tax 28 © Insyt Pty td 2010

29. Other issues Compliance issues with auditors Low-volume auditors High-volume auditors Tax agents Auditors with independence threats 29 © Insyt Pty td 2010

30. Disclaimer This presentation is general in nature and intended for educational purposes only. The presentation does not have regard to any particular person’s objectives, taxation or financial situation, legal requirements or other needs not expressly stated. The contents of this presentation do not constitute financial product advice, legal advice or other professional advice. Accordingly, you should not rely on, or act upon, the contents of this presentation without obtaining advice from a suitably qualified advisor because the material is generalised and is not specific to you or your client’s circumstances. Insyt is not engaged in providing legal, accounting, financial planning or any other professional service. Insyt, its associates, authors, or any agent, subcontractor, directors, officers, employees, representatives will not be liable to anyone for any damages (whether direct or indirect, consequential, punitive or exemplary) resulting from any error, omission or inaccuracy of any kind whatsoever from the presentation. Insyt expressly disclaims all and any liability to any person, whether they purchased the article or not, in respect of anything done or omitted to be done by any person in reliance in whole or in part on the contents of the presentation. 30 © Insyt Pty td 2010