Tax reduction schemes are not super

It is becoming a fairly frequent practice for a number of financial planners to engage in an undeducted contribution-based tax strategy, which is already the subject of a ruling by the Australian Taxation Office (ATO). This is being practised by some high-profile advisers.

The strategy consists of making an undeducted contribution (UC) to super shortly before receipt of a lump sum eligible termination payment (ETP) in order to wash higher taxed post ’83 components into lower taxed pre ’83 components.

There is nothing wrong with making a UC if the benefit is to be taken as a pension rather than cashed in. However, ATO Ruling IT 2393 is specific that a late UC, made just before the receipt of an ETP, is disallowed. It even suggests that the amount contributed would not be able to be rolled over.

The ATO has confirmed that this ruling remains current. I understand that the strategy is being considered for inclusion on the list of targets for the ATO to attack as aggressive tax schemes.

This is significant, as the ATO has shown a recent preparedness to take a very hard line on tax schemes in regard to retrospectivity and penalties. It is also speaking of targeting the advisers who promote tax schemes and earn fees from them more than the clients who have innocently followed their advice.

If advisers are going to promote so called aggressive tax strategies, they need to think carefully about the business risk they run.

In preparing this article, I contacted the technical advisers from a number of fund managers to obtain their views. From this, it was clear that the practice is widespread. There is also much uncertainty about how long before receipt of a benefit a UC would need to be made to be regarded as bona fide.

The example given in IT 2393 is of a contribution made “in the final month” of employment. The ruling argues that this deposit was not intended for genuine superannuation purposes but was to reduce tax.

Although there is no clear-cut guideline, some fund manager representatives suggest that the UC should be made at least six months before receipt of the benefit.

One manager suggested that, in any case, “nine times out of ten” it would not be found out. Indeed, under self-assessment, it would probably take a tax audit to identify that an individual had implemented the strategy, so the odds against discovery would be low.

However, if this is the spirit in which a strategy is recommended, surely a client is entitled to clear disclosure of this, that is, to be advised:

That the practice may be of dubious legality;

The estimated probability of getting caught and the possible penalties; and

The tax saving achieved.

This puts the client in a position to make an informed risk/return assessment. A professional adviser should do no less than this, both for the client’s sake and as protection against a possible liability claim.

For the planner to present the strategy without a warning, as if it is unquestionably bona fide, is misleading and would appear to open a clear pathway to a possible claim. Without this being in writing, a planner usually will lose a ‘my word against yours’ style court case about whether the risks were explained.

However, where written advice recommends making a UC and subsequently cashing in the ETP, and highlights the tax saving, it would be difficult to claim to not be promoting a scheme. In the event of a tax audit of a client, this might invite unpleasant ATO attention onto the planner - and consequently other client files.

In a previous edition ofMoneyManagement(July 5, 2001), a former tax ombudsman suggested that planners who recommended tax-effective schemes could face a raft of penalties. The article stated that a planner who received a commission for recommending a tax-effective scheme could be subject to a penalty for each time they have done so.

The Commissioner of Taxation, Michael Carmody, has recommended to the Federal Government that it adopts measures along these lines, similar to those used in the US and Canada to deal with the promoters of tax schemes.

Our industry has seen a number of financial planning firms, who actively encouraged film or agricultural tax effective strategies, have their practices badly damaged when these came unstuck.

I suspect that many planners who may recommend this form of UC strategy do not see themselves as promoters of tax avoidance schemes. This is surely naïve if they are recommending strategies which reduce tax in a way that has already been subject to an adverse tax ruling.

A planner who advises contrary to a tax ruling must either be ignorant of it, have a policy of ignoring rulings, believe that this ruling is wrong in law and that their clients should fight it in court if challenged, or simply hope that their client’s action will not come to ATO scrutiny.

Whichever of these applies, the client is surely entitled to be warned that this is the basis for the advice.

Quite properly, financial planners wish to structure their clients’ affairs in the most tax efficient manner. The line between legitimate tax planning and illegal tax avoidance has always been grey.

In this case, there is obvious uncertainty about how long before receipt of an ETP must a UC be made to be seen as bona fide. If the ATO intends to attack this strategy it should also offer clear guidelines on this.

However, where a practice has been proscribed by a ruling, considerable caution should be applied in recommending it. Yet, in this case, the strategy is becoming quite widespread.

Those planners who recommend this strategy are running a business risk, which should be carefully assessed.

Finally, please note that the UC strategy described above should not be confused with “recontribution” strategies (ie cashing in super and making a subsequent UC to an allocated pension). Further, IT 2393 does not disallow contributions when they are to obtain a pension.

Rob Keavney is the managingdirector of Investor SecurityGroup (ISG).