Inappropriately diverting income to SMSFs: ATO offers penalty remission to those who act early

The Australian Tax Office is offering a penalty remission to self-managed super fund (SMSF) members who come forward before January 31, 2017, with details about arrangements they may have entered into to divert their personal services income into the fund.

While the ATO recognises the importance of preserving the assets that SMSFs hold to fund retirement incomes, it is not happy about some arrangements it has become aware of.

The ATO has concerns about individuals at or approaching retirement age (usually members of SMSFs) diverting their personal services income to SMSFs in order to minimise or avoid tax on their income.

In essence, personal services income is income produced mainly from a person’s personal skills or efforts as an individual. Examples include income generated by construction workers, medical practitioners, engineers and IT consultants.

Under the tax law, income is classified as personal services income when more than 50% of the amount a person receives for a contract was for their labour, skills or expertise.

The ATO issued Taxpayer Alert TA 2016/6 in late April this year outlining its concerns. The kinds of arrangements under the spotlight are where a SMSF member performs services for a client for which the individual does not directly receive any (or adequate) payment. The client does not pay the individual directly, but rather pays a company, trust or other non-individual entity. The entity may be an unrelated third party.

The entity then distributes the income to a SMSF, of which the individual is a member, purportedly as a return on an investment of the SMSF in the entity. The trustee of the SMSF treats the income received as subject to a concessional rate of tax, or as exempt current pension income of the SMSF.

As a result, the ATO is undertaking reviews of a number of cases involving arrangements of this type and it plans to discuss the matter with affected taxpayers (and their advisers) over the coming months.

The ATO is encouraging taxpayers who have entered into a similar arrangement to contact it so it can help resolve any issues in a timely manner and minimise the impact on the individual and the fund.

Where individuals and trustees come forward to work with the ATO to resolve issues, the ATO says it anticipates that in most cases, the personal services income distributed to the SMSF by the non-individual entity would be taxed to the individual at their marginal tax rate.

The ATO says issues affecting the SMSF will be addressed on a case-by-case basis, but it will take the individual’s co-operation into account when determining the final outcome.

In a concession, the ATO says individuals and trustees who are not currently subject to ATO compliance action, and who come forward before January 31, 2017, will have administrative penalties remitted in full. However, shortfall interest charges will still apply.

The ATO encourages people who are contemplating entering into the arrangements in question (or similar) to contact it first. They could even seek the ATO’s views through a private ruling.

More information is available on the ATO website.

Terry Hayes is the editor-in-chief of tax news reporting at Thomson Reuters, a leading Australian provider of tax, accounting and legal information solutions.