The Australian Taxation Office (ATO) has recently issued a warning to taxpayers involved in property development projects with self-managed superannuation funds (SMSFs).
The ATO’s Taxpayer Alert TA 2023/2 highlights concerns about schemes that are perceived to lack commerciality and funnel profits to SMSFs through special purpose vehicles (SPVs) and non-arm’s length arrangements.
The concern
The ATO is closely monitoring situations where SMSFs gain direct or indirect ownership of SPVs for property development projects.
In these cases, the minds behind property development groups establish SPV(s) that enter into non-arm’s length contracts with related entities to carry out the development work. These related entities charge lower fees than the usual arm’s length rates, leading to inflated profits for the SPVs and benefiting the SMSFs.
The end result may be that the SPV reports a higher profit than usual, and these profits are then passed on to SMSF shareholders via dividends, who enjoy concessional tax rates.
Consequently, the effective tax rate on profits from the development project can be reduced from the minimum 25% company tax rate to the 15% complying self-managed superannuation fund tax rate (or exempt if the dividends are supporting pension payments to the member(s) of the SMSF).
Example: Diversion of Profits through Non-Arm’s Length Contracts
Consider Taxpayer 1 and Taxpayer 2, who are members and trustees of their respective SMSFs.
They establish two SPV companies. The first is an SPV called “New Development Co” for a property development project. New Development Co is owned 100% by New Interposed Co which is owned 50% each by Taxpayer 1 and 2 respective SMSFs.
New Development Co contracts with related entities, Civil Works Tpr 1 Pty Ltd and Management Tpr 2 Pty Ltd, to conduct property development and project management. However, the fees charged by these related entities are significantly below the arm’s length rates.
As a result, New Development Co earns inflated profits from the property development project.
These profits are then distributed as franked dividends to New Interposed Co, which is 50% owned by each SMSF. Consequently, the dividends received from New Interposed Co are assessed at a 15% tax rate or are exempt if the shares in New Interposed Co are supporting the payment of pensions to members of SMSF 1 or SMSF 2.
Risks and penalties
Taxpayers and promoters involved in these arrangements face substantial risks and potential penalties.
The ATO urges taxpayers considering or already engaged in such arrangements to exercise caution and consider their options. Taking proactive steps like seeking independent professional advice, requesting private rulings from the ATO, or making voluntary disclosures to mitigate potential penalties are crucial actions taxpayers can take.
Conclusion
The ATO’s Taxpayer Alert TA 2023/2 serves as a reminder to taxpayers and their advisors that complex structures primarily designed for tax purposes may come under the Tax Commissioner’s review and potentially broader interpretation of existing tax laws.