Assets constituting trading stock were once the exception to the rule, as they did not have to be treated according to the CGT provisions. DBA Lawyers' Bryce Figot and Nathan Papson explain the effects of changes introduced by the Federal Government last year.
Complying superannuation funds are generally required to treat all gains and losses made on assets according to the capital gains tax (CGT) provisions.
One exception was assets constituting trading stock. On Federal Budget night 2011 the Federal Government announced that it would abolish this trading stock exception for certain assets.
This announcement has led to draft legislation that raises a number of interesting issues for self-managed super funds (SMSFs).
Proposed amendments
Changes
The Tax Laws Amendment (2012 Measures No 1) Bill 2012 was introduced on 21 March, 2012. The bill limits complying superannuation funds’ ability to treat gains and losses from certain assets’ shares on revenue account.
These assets are shares, units in a trust, land and similar assets. Gains and losses will be treated in accordance with CGT provisions.
The Explanatory Memorandum (‘EM’) to the bill gives an example of an SMSF engaging in a share-trading business during the 2012 financial year.
The gains and losses of those shares are to be treated as capital gains and losses, as opposed to revenue gains and losses.
The bill took effect on 7.30 pm on 10 May 2011.
As such, most assets acquired by complying superannuation funds must be treated according to the CGT provisions.
However, assets held as trading stock prior to this date can continue to be taxed on revenue account.
Policy
The EM states that “during the recent economic downturn, a number of superannuation entities sought, for the first time, to treat some of their shares as trading stock”.
This practice creates potential uncertainty regarding the appropriate tax treatment of gains and losses made from the sale of shares owned by complying superannuation entities.
This has created the need to amend the law to reduce the present ambiguity around the application of the trading stock provisions.
SMSFs running a business
No prohibition
The introduction of this bill can be seen as implicit acceptance that complying superannuation funds can run businesses. That is, it acknowledges that complying superannuation funds might have trading stock and thus are running a business.
This raises the old question: are complying superannuation funds allowed to run businesses?
ATO’s view
The ATO has also acknowledged on its website that an SMSF can run a business. Its position is as follows:
“The fact that activities undertaken by an SMSF trustee are considered business activities for income tax purposes does not necessarily mean that the trustee contravenes the regulatory provisions.
However, trustees should be aware that those activities might breach the sole purpose test or other regulatory provisions.”
These comments suggest SMSFs running businesses might come under close ATO scrutiny.
Case law
At the risk of over-simplifying, the 2008 High Court decision of Commissioner of Taxation v Word Investments Ltd (2008) 236 CLR 204 considered whether a company that ran a business met the charity equivalent of the sole purpose test.
The company ran a funeral business charging clients a commercial margin of profit. Profits were then donated to another entity that clearly was a charity.
Effectively this raised the question of whether the ends can justify the means.
Four out of five judges answered in the affirmative, holding that the company’s activities were charitable because they were carried out in furtherance of a charitable purpose.
Although not expressly a superannuation case, Word does have implications for superannuation funds.
Namely, it lends support to the view that superannuation funds running a business meet the sole-purpose test if the business profits are retained in the fund to pay for things like retirement benefits.
Tax treatment of trading gains and losses
Discounted capital gains
As outlined above, the bill provides that certain losses and gains must be taxed under the CGT provisions. In the context of share trading, a capital gain or loss will be made each time a share is sold.
An SMSF may be eligible to apply a 33.3 per cent discount percentage to its capital gains (less losses).
The application of this discount percentage is subject to a number of provisos. For example, the asset must be held for at least 12 months before the CGT event is made.
This discount percentage has the ultimate effect of reducing the ‘net capital gain’ included in the SMSF’s assessable income.
Revenue vs capital losses
Broadly, a net capital loss in a financial year can be carried forward and applied against capital gains in future years.
Therefore, SMSFs may not reap the benefit of net capital losses in the current financial year.
In contrast, losses on shares that were trading stock previously provided SMSF trustees with an immediate deduction.
However, losses on most trades made after 10 May, 2011 are not eligible to be treated in this manner. An exception to this is if the shares were treated as trading stock prior to 10 May 2011.
Conclusion
The bill will have a significant impact on SMSFs running businesses, particularly a business of share trading.
Bryce Figot is senior associate and Nathan Papson a lawyer at DBA Lawyers.
