Year end tax strategies - There will never be a better time

1. Take advantage of the proposed small business investment allowance

The additional small business allowance was originally announced on December 12, 2008, and significantly modified on February 3, 2009.

Under the proposal, eligible small businesses will be able to claim an additional tax deduction of 30 per cent for new investment in tangible depreciating assets used in running a business.

To qualify, the new investment must be more than $1,000, the investment must be undertaken between December 13, 2008, and June 30, 2009, and the asset must be ready for use in the business by no later than June 30, 2010.

For any small businesses that cannot qualify for the 30 per cent additional tax deduction, a 10 per cent deduction will apply where the same new investment is made between December 13, 2008, and December 31, 2009, and the asset is ready for use in the business by the end of December 2010.

Businesses that are not eligible small businesses can access a similar set of bonus deductions, with the exception that new investment of at least $10,000 is required.

For small business clients, this is a great opportunity to gain additional tax benefits by bringing forward required expenditure to this financial year.

It is important to note that at the time of writing, this proposed measure has not been legislated.

2. Transitional in-house asset rules — last chance for SMSFs to make certain new investments

Since 1999, when substantial changes were made to the definition of an in-house asset, transitional rules have existed to allow certain related party assets held at that date, which would not have been considered in-house assets under the previous rules, to remain permanently exempt from being considered an in house asset under the current legislation.

These assets commonly include geared private unit trusts and companies, assets leased to related parties and loans to related parties. Investments in non-geared unit trusts and companies purchased at any time that meet certain conditions can be exempt from the in-house assets test under a different rule.

In addition, the transitional rules provide that additional investments into these related party structures can be made in specific situations until June 30, 2009, and are also exempt from the in-house assets test. These situations include:

n investments made to complete the payment of partly paid units or shares; and

n the reinvestment of distributions or dividends.

Super funds with fewer than five members that were invested in a geared related trust or company at August 11, 1999, also had the option of making an election under section 71E of the Superannuation Industry (Supervision) Act 1993 (SIS Act). The election must generally have been made by December 23, 2000.

This election allows the fund to make additional investments in that trust or company between August 11, 1999, and June 30, 2009, up to the value of the loan in the trust or company at August 11, 1999. However, if this election was made, the above transitional measures in relation to partly paid units or shares and the reinvestment of distributions or dividends no longer apply.

Where additional investments are being made by a self-managed superannuation fund (SMSF) under one of the above transitional arrangements, any additional investment made after June 30, 2009, will be an in-house asset of the fund. It is therefore important for advisers with SMSF clients in this situation to look at the current investment arrangements and determine whether changes are required at the end of this financial year. This might include:

n making remaining payments on partly paid shares by June 30, 2009, if possible;

n ceasing the reinvestment of distributions or dividends; and

n if a section 71E election was made, considering increasing additional investment in the geared trust or company prior to June 30, 2009, and ceasing new investment after that point.

While there is not necessarily anything wrong with an SMSF holding a small amount of in-house assets, if they represent more than 5 per cent of the balance of the fund at the end of an income year, the in-house assets test will be breached. This will likely lead to the fund being forced to sell down in-house assets in the following income year.

3. Super contribution options

Contributing to super can often provide substantial tax benefits and some of the more beneficial contribution strategies are outlined below. It is important to note that limits may apply to the level of contributions that can be made without additional tax being incurred.

Salary sacrifice

Swapping some salary for increased employer super contributions remains one of the best strategies for many clients to reduce income tax while at the same time maximising future retirement benefits. Not only will clients receive an initial reduction in tax, the money contributed will then be indefinitely invested in a concessionally-taxed environment.

This is certainly a strategy to look at for clients who have a marginal tax rate of 30 per cent or more and who won’t require the contributed money until retirement.

Personal concessional contributions

For those not receiving a salary and therefore unable to salary sacrifice to super, personal concessional contributions provide an equivalent tax benefit for those who are substantially self-employed or not working. This type of contribution is created by a client making a personal contribution to super, then submitting an approved form to their fund electing to treat some of their contributed money as a concessional contribution. A full tax deduction then applies for the amount of their concessional contribution.

There are also strict timeframes that apply for the submission and acknowledgement of the approved form, particularly where the client is using the contribution to withdraw or rollover money from their super fund or commence an account-based pension.

Government co-contribution

The government co-contribution is a scheme where the Government will contribute 150 per cent of an eligible client’s personal after-tax contributions during a financial year, up to a calculated maximum.

The Government’s calculated maximum is $1,500 less 5 per cent of any assessable income and reportable fringe benefits that a client has above $30,342 (reduces to $0 when income reaches $60,342).

Many clients will shortly be receiving cash payments of up to $950 as part of the Government’s Nation Building and Jobs Plan. These payments may provide the client with the ability to make an after-tax contribution and have their super fund receive a further government payment by qualifying for the co-contribution.

A strategy to consider in this financial year that can maximise the government co-contribution is a salary sacrifice combined with an after-tax contribution of $1,000. Salary sacrifice has the effect of reducing assessable income, which can increase the calculated maximum co-contribution.

For example, Greg has assessable income (salary) of $65,000 and will therefore not receive a co-contribution, even if he makes an after-tax contribution to super. However, if Greg salary sacrifices $35,000 and makes an after-tax contribution of $1,000, he will then qualify for the maximum co-contribution of $1,500.

You should consider taking advantage of this strategy for your clients in this financial year since, unfortunately, this strategy is unlikely to be possible in future financial years, with salary sacrifice contributions proposed to be included in the definition of ‘income’ for co-contribution purposes from July 1, 2009.

4. Gearing/instalment gearing/prepayment of interest

A common tax effective strategy is gearing, which can include borrowing for investment through a home equity loan, margin loan or protected loan. Interest payments are generally tax deductible, although in some cases, such as protected loans, only a part tax deduction may apply.

Gearing will provide a lower tax bill each year if the deduction for interest payments is greater than the assessable income from the investments. However, the overall aim of the strategy must still be for the net income and capital gain from the investments to be greater than the net interest cost.

It is also possible to claim a deduction for prepayment of up to 12 months of interest payments, which allows a client to prepay the next financial year’s interest bill in June 2009 and reduce their tax with a larger deduction this financial year. Care should be taken when estimating the amount of interest that will apply next financial year — for this reason it is worth considering a fixed interest rate during the period of prepayment.

For clients who are not willing to invest all of their money into a gearing strategy because of the current global market uncertainty, you could consider recommending an instalment gearing strategy. By gradually building up a gearing strategy over time, the client has the benefit of dollar cost averaging. Many of the risks associated with gearing are also reduced where an instalment gearing strategy is used.

It is important to remember that a gearing strategy increases risk and is therefore not appropriate for all clients. Other issues that need to be considered in conjunction with this strategy are the risk tolerance of the client, their investment timeframe, surplus cash flow and income protection insurance. Where a margin loan is used, the possibility of a margin call must also be considered.

5. Small business retirement exemption involving a discretionary trust

Where a discretionary trust is selling eligible capital gains tax (CGT) assets and wishes to claim the small business retirement exemption, it must satisfy the small business entity test or net asset value test, as well as the active asset test.

The next requirement is that it has a ‘significant individual’ just prior to the CGT event. A significant individual is a person who has a small business participation percentage of at least 20 per cent.

Once these requirements have been met, the trust can pay an exempt amount to each of its CGT concession stakeholders, up to each stakeholders’ CGT retirement exemption limit ($500,000 reduced by any amounts previously counted). A CGT concession stakeholder is either a significant individual or the spouse of a significant individual with a small business participation percentage of greater than nil.

The concept of the small business participation percentage is therefore critical, as it determines, firstly, whether a trust will be able to qualify for this exemption (does it have a significant indiviual?) and, effectively, how many CGT retirement exemption limits it is able to utilise (how many CGT concession stakeholders does the trust have?).

Small business participation includes direct participation by the individual in the trust as well as indirect participation by an individual in the trust through another entity.

For a discretionary trust, participation is generally the lesser of the individual’s entitlement to any income distributed and entitlement to any capital distributed during the year. For example, if an individual received 25 per cent of all income distributed and 30 per cent of all capital distributed during an income year, they would have a small business participation percentage of 25 per cent.

Because they are generally in a position to determine where income and capital distributions will be paid, discretionary trusts are relatively well placed to benefit from the small business retirement exemption. For trusts looking to claim the exemption, careful planning of income and capital distribution is required during that income year to ensure qualification, as well as ensuring that the amount claimed is maximised.

This will, firstly, include ensuring the trust has a significant individual by directing at least 20 per cent of income distributions and at least 20 per cent of capital distributions to one individual.

Secondly, by distributing at least some income and capital to the spouse of a significant individual to allow them to qualify as a CGT concession stakeholder, the trust may in some cases double the exemption it can claim.

6. Transition to retirement/salary sacrifice strategy

The transition to retirement (TTR)/salary sacrifice strategy, which involves replacing salary with payments from a TTR pension and increasing salary sacrifice contributions, has become one of the most widely used strategies to maximise retirement benefits for those working beyond age 55.

The two main benefits of this

strategy are:

n the balance used to commence a pension will no longer have its earnings taxed; and

n the pension payments received may be subject to less tax than the salary they replace, and in many cases are tax free.

For example, Sarah, who is aged 60, has salary of $100,000 (her only income), which gives her after tax income of $72,500. She has a super balance of $400,000 in a taxed super fund.

If Sarah were to commence a TTR account-based pension with her full super balance, she can draw a pension payment of up to $40,000 in the first financial year, which will be received completely tax free. This allows Sarah to elect to salary sacrifice $63,411, or $53,899 after allowing for maximum contributions tax. In other words, she has just increased her overall super balance by $13,899 without giving up any net income. Any tax saved due to the majority of her balance being in pension phase will provide a further benefit to Sarah’s super balance.

The TTR/salary sacrifice strategy does not just work with salary sacrifice contributions. For those who are self-employed or no longer working, similar benefits can be received by undertaking this strategy with personal concessional contributions. In some cases (such as those on a low taxable income or those over 60 who have used up their concessional contribution cap), it may be worth considering this strategy with after-tax contributions.

Care should be taken when considering this strategy for clients utilising their full contribution caps and for clients under age pension age receiving social security benefits.

Tim Sanderson is technical services manager at Count Financial.