Will FOFA be followed by TOFA?

While the proposed Future of Financial Advice changes and their potential impact on financial advisers remain the hot topic, there is another acronym – TOFA – which deserves attention, according to David Barrett.

The impact of Future of Financial Advice on financial planners dominates the financial press, but there’s another similar acronym, TOFA, which also deserves some attention.

TOFA (Taxation of Financial Arrangements) refers to a new division of the Income Tax Assessment Act (ITAA) 1997 that aims to provide a modern, more efficient and lower compliance-cost taxation regime for financial arrangements.

Many superannuation funds and managed investment schemes began complying with the TOFA provisions from 1 July 2010. The substantial administration system changes required have come at considerable cost to many funds, for what now appears to be a relatively minor revenue gain for the Government.

Nonetheless, as the 2010/11 taxation reports begin to filter out to clients, the impacts for some clients will be evident.

In this article we explain the key impacts on clients stemming from the TOFA regime.

Who and what does TOFA affect?

TOFA became effective for certain taxpayers voluntarily from 1 July, 2009 and was mandatory for those who didn’t opt in from 1 July, 2010. However, the threshold tests result in many taxpayers falling outside the TOFA regime, unless they voluntarily opt in. The threshold tests are:

• Authorised Deposit-taking Institutions (ADIs), securitisation vehicles and financial sector entities, with an aggregated turnover of $20 million or more in the previous income year
• Superannuation entities, managed investment schemes and foreign entities similar to managed investment schemes, if the value of their assets is $100 million or more
• Other entities (not individuals) who meet any of the following thresholds in the previous income year:

1. 1. Aggregated turnover of $100 million or more 
   2. Assets of $300 million, or 
   3. Financial assets of $100 million or more.

Individual taxpayers are generally not required to comply with the TOFA regime, unless they choose to opt in.

Broadly, TOFA is a shift from taxation based on realisation of certain receipts, to an accruals basis of taxation where financial gains and losses are attributed as derived rather than as realised.

Likely impact on clients (and financial advisers)

For those clients who don’t opt in, the most likely impact of TOFA is taxation adjustments to their superannuation funds and managed funds, where those entities exceed the $100 million asset threshold. Generally, TOFA will not apply to SMSFs.

However, for superannuation funds the capital gains taxation provisions in ITAA 1997 explicitly take precedence over the TOFA provisions.

Hence TOFA generally has application only to a limited range of mostly debt and fixed interest-type investments held by superannuation funds, including term deposits, certain convertible notes and a limited number of stapled securities. 

The impact of TOFA on the taxation of term deposits largely relates to the timing of income being bought to account.

Prior to the commencement of TOFA (1 July, 2010 for those funds which chose not to start from 1 July, 2009), interest from term deposits was subject to taxation only in the year it was paid to the fund. TOFA, on the other hand, apportions the income generated by a term deposit over the accrual period. The change in treatment is best understood by looking at an example.

Example

Assume Jenny is a member of a large retail superannuation fund. On 15 July 2010 she directs the fund to purchase a 12-month term deposit (TD) with $100,000. The TD yields 6 per cent, payable upon maturity on 14 July 2011.

Prior to the commencement of TOFA, the $6,000 interest payment would have been taxable in the year it was paid to the superannuation fund; ie, 2011/12. See Diagram 1.

The introduction of TOFA changes this tax position significantly. TOFA requires the superannuation fund to attribute the income on an accruals basis, and apportion it to both the 2010/11 and 2011/12 income years based on a prorating of the days of the investment term. This apportioning results in $5,770 of taxable income in the 2010/11, and $230 in 2011/12. See Diagram 2.

It’s important to bear in mind that although TOFA causes an increase in taxable income for the superannuation fund in 2010/11, this is simply a bringing forward of a tax liability that generally would otherwise have applied in 2011/12 anyway. The impact is simply a timing issue.

However, in some situations the impact might be more than a simple timing difference, as described below.

Switching to pension phase

Suppose now that Jenny switches to pension phase on 1 February 2011. Ordinarily (that is, prior to TOFA commencing) the interest from her TD would be paid to the fund (on 14 July 2011) when Jenny’s account is in pension phase, and the income would be exempt from taxation. 

With the introduction of TOFA, the current industry practice is that the income attributed to the period prior to switching to pension phase is taxable at 15 per cent.

So Jenny’s account incurs $495 more tax (ie $3,304 at 15 per cent) than it would have under the pre-TOFA rules. Diagram 3 illustrates the taxation implications of a pension switch on 1 February 2011.

Conclusion

TOFA is unlikely to have a large impact on most clients of financial advisers. Some clients might, depending on their investment selections, experience a greater tax liability on their accounts with large superannuation funds and managed funds in the year TOFA applies to that fund (generally 2010/11).

This may be apparent where the superannuation fund reporting provides detail of the tax liability deducted from individual accounts, but many superannuation funds may not provide this level of detail.

Ultimately the impact of TOFA may simply be a bringing forward of certain tax liabilities in relation to certain securities – in general no additional tax liability is incurred, if the timing difference is ignored.

However, in some situations a tax liability may result prior to income being distributed, possibly resulting in funding issues for that liability.

In addition, some income that was previously exempted in pension phase may now be partially taxable in proportion to the period attributable to accumulation phase.

David Barrett is head of MAStech, Macquarie Adviser Services.