The appeal of self-managed super funds (SMSF) mostly comes from having greater control over your investment choices and how you manage your super savings. As an SMSF trustee, you have flexibility to buy and sell investment assets, which helps you gain a deeper understanding of how your wealth is growing. Ideally, this allows you to have more confidence in your investment and lifestyle decisions.

By having greater control of your assets and investment decisions, SMSFs can also offer trustees more control over the taxation of their super. But to better manage the tax position of your SMSF, you must be aware what rules are applied and how the fund’s earnings are taxed. 

Let’s look at the ground rules on how SMSFs are taxed and how you can avoid paying tax penalties.  

How are SMSFs taxed?

An SMSF is treated like a retail, industry and corporate fund for tax purposes by the Australian Taxation Office (ATO). But unlike the mentioned funds, trustees have greater control of taxation matters in an SMSF. Because trustees have a final say about investment decisions, they can determine when an asset can be sold, which could impact how much tax the fund needs to pay. 

According to the ATO, the tax rate on income within a superannuation fund (including an SMSF)  is 15 per cent. However, there are special rules that apply when a fund is paying a pension to members. There is no tax payable within the fund on income produced by assets fully supporting an income stream such as a pension. 

The types of accessible income for a complying SMSFs include the following: 

• assessable contributions (includes employer and personal deductible contributions) 
• net capital gains (capital gains less total capital losses, and less a one-third capital gains tax discount for an asset owned by the fund for a year or more); and
• interest, dividends and rent.

What is a non-arm’s length income?

According to the ATO, SMSFs must transact on an arm’s-length basis. This means that the buying and selling price of SMSF assets should always reflect the true market value of the asset, and the income from assets held by your fund should always show the true market rate of return.

Any non-arm’s length income (NALI) by the fund is classified as activity and investment that fall outside the 15 per cent tax rate. These earnings (which are taxed at the highest marginal rate) includes income:

• originated from a scheme or investment in which the parties are not dealing with each other at arm’s length
• greater than the amount that the SMSF might have been estimated to get if involved parties had been dealing with each other at arm’s length
• income earned by an SMSF as a beneficiary of a discretionary trust
• dividends paid to an SMSF by a private company (unless the dividend is consistent with arm’s-length dealing).

What is a no-TFN contribution? 

Another type of SMSF income is a no-TFN contribution. These are contributions made where the SMSF does not hold the member’s Tax File Number (TFN) on file. 

If the member has not quoted their TFN, the trust will need to pay additional tax on their required employer contributions and cannot accept other type of contributions. And the additional tax rate is quite hefty. It is 34 per cent for complying SMSFs and 2 per cent for non-complying SMSFs.

If you pay additional tax and your member eventually gives you their TFN, you can claim back the additional tax as a non-TFN tax offset in your SMSF annual tax return. But you can only claim this offset from the end of the financial year that the contributions subject to the additional tax were made. 

How can my SMSF avoid tax penalties?    

Generally, keeping your SMSF compliant is the best way to avoid tax penalties. Aside from being informed about the ground rules on taxation on SMSFs, here are some rules you should take note of to avoid costly penalties. 

• Lending – You cannot lend money to yourself or any other trustee (this also covers the relatives of trustees). If you do so, ATO can declare your fund non-compliant and impose a higher tax rate and significant penalties. 
• In-house assets – SMSF assets cannot be utilised for personal benefit. For example, you can’t purchase a holiday house for private use using fund assets. But there are loopholes to this. If your SMSF purchases that very same holiday house and rents it to non-related parties, it may be allowed. Also note that no more than 5 per cent of your SMSF can be invested in “in-house assets” (e.g. investment in a trustee or member’s business). Rules relating to in-house assets are complex and can be difficult to navigate, so make sure to seek professional advice regarding this matter. 

Conclusion

Self-managed super funds can give trustees more control over the taxation of their super. But  like all aspects of SMSFs, there are rules that apply and should be followed. To help your fund avoid making unintentional mistakes, you should ensure that your fund’s accountant or financial adviser can give you the proper guidance when navigating the rules around capital gains tax and how it might apply to an SMSF, its trustees and members. Being aware of what you can and cannot do endows you with the power to take advantage of the control and flexibility which SMSFs can give. 

Ready to set up your own SMSF? Read here.