Property Development & SMSFs: TA 2023/2 Guide

Taxpayer Alert TA 2023/2 

On 15 June 2023, the ATO issued Taxpayer Alert TA 2023/2. This alert addresses situations where a self-managed superannuation fund (SMSF) has direct or indirect ownership of a special purpose vehicle (SPV) that undertakes a property development project.

The Commissioner is particularly concerned about situations where an SPV contracts with related entities, often with the same directors, to carry out the property development work, and the price charged by the related entities is less than what would be expected in an arm's length arrangement. As a result, the related entities derive lower (or nil) profit, and the SPV earns higher profits than expected if the SPV and related entities dealt with each other on an arm's length basis. As a result, the related entities pay less tax (as they have less profit), and the SMSF receives dividends or distributions from the SPV, which are higher than it would have been if the SPV dealt with the related entities on an arm's length basis.

The Commissioner is also concerned about situations where related entities or the SPV, or both, enter into loans to facilitate the property development project, and the terms of those loans are inconsistent with an arm's length dealing.

The Commissioner is concerned about these arrangements because they lack commerciality and divert profits to an SMSF, where those profits can be taxed at a more concessional rate.

Example Provided in the Alert 

The Alert includes the following diagram of a detailed example of this type of arrangement:

In this example, Taxpayer 1 is the member and trustee of SMSF 1 and a shareholder & the director of Civil Works Tpr 1 Pty Ltd. Taxpayer 2 is the member and trustee of SMSF 2 and a shareholder and director of Management Tpr 1 Pty Ltd. SMSF 1 and SMSF 2 each own 50% of XYZ Interposed Co. XYZ Interposed Co owns 100% of New Interposed Co (this is the SPV) and those shares are issued for a non-arm’s length nominal price.

New Interposed Co subcontracts the property development functions to Civil Works Tpr 1 Pty Ltd and property development project management functions to Management Tpr 2 Pty Ltd. Civil Works Tpr 1 Pty Ltd and Management Tpr 2 Pty Ltd each provide a working capital loan of $30 million to New Interposed Co, and these loans are on non-arm’s length terms, including no interest and no set repayments of principal and interest. Civil Works Tpr 1 Pty Ltd and Management Tpr 2 Pty Ltd each charge non-arm’s length fixed fees below the fees they would charge third parties for the same services.

New Interposed Co contracts with the property owner to enter into a property development project. New Interposed Co pays franked dividends to XYZ Interposed Co, and XYZ Interposed Co pays franked dividends to SMSF 1 and SMSF 2.

As a result, New Interposed Co earns profits that are more than would have been expected if the company was dealing at arm’s length, and these profits were then diverted to the SMSFs through the payment of dividends. As a result, the SMSFs pay a 15% tax on the dividends (or 0% if the shares support the payment of pensions to members of the SMSF), and the SMSFs are entitled to a refund of any excess franking credits.

Suggestions for Trustees Using SMSFs for Property Development Projects 

Non-arm's length income (NALI) refers to income generated by a superannuation fund pursuant to a non-arm's length arrangement. Income is classified as NALI if the income is more than what the fund would have received if the fund was dealing at arm's length. Where the income of the fund is classified as NALI, it is taxed at the highest marginal rate (45%).

Previously, it was argued that the NALI provisions don't apply if the SMSF is not directly involved in non-arm's length dealing. However, case law has confirmed that non-arm's length dealings by any party in relation to a scheme involving an SMSF can give rise to NALI.

This alert is a reminder to trustees of SMSFs that they need to ensure each step of a scheme or a property development project (in this case) is dealt with on an arm's length basis. This means, among other things, that the trustee should ensure that:

• the acquisition of any shares in the scheme should be for arm's length market value;
• all loans should be made on arm's length terms; and 
• any related entities should be charging arm's length prices for the work performed. 

If the parties are not dealing at arm's length in any of the steps of the scheme, the income relating to the property development project derived by the SMSF (including any capital gains) may be classified as NALI and subject to tax at the highest marginal rate (45%).

Further, the trustee should ensure that the SMSF meets the sole purpose test of providing retirement benefits to its members (or to the members' dependants upon their death). The ATO is concerned that these types of arrangements may contravene the sole purpose test and other requirements under the Superannuation Industry (Supervision) Act 1993 (Cth) (SIS Act), like the in-house asset rules and the rules regarding SMSFs borrowing money.

If the Commissioner determines that the scheme is inconsistent with the SIS Act, it can disqualify a person from acting as trustee or director of a corporate trustee of an SMSF. Further, the Commissioner can issue a notice of non-compliance, which will essentially result in any income of the SMSF and the market value of the entire SMSF being taxed at the top marginal rate (45%). Although a notice of non-compliance is a drastic measure, and the Commissioner will often allow the SMSFs to rectify the issues first, it is an avenue available to the Commissioner and something that trustees should consider.

Finally, if the Commissioner determines that the property development project is a scheme that the parties entered into or carried out for the sole or dominant purpose of obtaining the tax benefit, the Commissioner can make a determination under Part IVA of the Income Tax Assessment Act 1936 (Cth) unwinding any tax benefit and imposing penalties and interest.