As all trustees are well aware, amendments made to sections 56(2) and 57(2) of SIS widened the indemnity restrictions under those provisions to effectively deny superannuation fund trustees and directors the opportunity to use superannuation fund assets to indemnify themselves from any liability to pay any form of Commonwealth penalty, regardless of the cause or how small that liability may be.

Trustees are taking different approaches to addressing this risk but the methods usually consist of the trustee charging new or higher direct fees or increasing indirect costs to members to build a sufficient trustee capital reserve to pay potential future penalties against which the trustee and its directors cannot be indemnified (Trustee Reserve).

TD 2023/D3 considers two scenarios by which money funding the Trustee Reserve travels out of the fund and into the Trustee Reserve:

• the trustee charges the fund additional specific fee amounts (as a lump sum or as a short- to medium-term recurring payment) for the purpose of enabling the trustee to immediately build a sizeable Trustee Reserve over the course of a few years; or
• the trustee increases its service fee/charges to commence funding of the Trustee Reserve (this strategy would take considerably longer for the Trustee Reserve to reach a substantial size).

In TD 2023/D3, the ATO expressed that under the general deduction provision – section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) – additional specific fees paid into a risk reserve are not deductible, but an increase to the existing ongoing recurrent charges for trustee services can be.

Those views are debatable. The rationale behind the distinction requires more clarification as it leaves questions as to why form should have such precedence over substance. In our opinion, each arrangement should continue to be assessed on its own facts.

However, there is a greater penalty risk in taking a position that is inconsistent with the ATO’s views. Trustees considering adopting a different position should seek independent tax advice based on their unique circumstances both as to correct characterisation and to understand how to manage the penalty risk.

General deduction provision – section 8-1 ITAA 1997

Section 8-1 of the ITAA 1997 governs when income tax deductions can be claimed. Broadly, an entity can deduct from assessable income any loss or outgoing to the extent that:

• it is incurred in gaining or producing assessable income; or
• it is necessarily incurred in carrying on a business for the purpose of gaining or producing the entity’s assessable income.

However, there are exceptions. One of those is expenditure that is capital in nature.

In broad terms, expenditure is capital in nature if what it secures is necessary for the structure of the overall business – that is how the organisation is set up or established for earning profit/achievement of its purpose. An amount is regarded as revenue in character if it goes to the process by which an entity operates to obtain regular returns/profits.

ATO’s views in TD 2023/D3

The ATO’s view of additional risk reserve payments is that the amount is more than a mere provision or ongoing provision of the trustee services. From the ATO’s perspective, “since the fund is already separately remunerating the trustee for the provision of their services to the fund, consideration of what the separate payment(s) is or are for is required.” It is also expressed that the payments secure an enduring benefit that goes toward the profit-yielding structure of the fund as opposed to its day-to-day activities, which makes the amounts capital in nature.

In contrast, increased trustee service fees are deductible. The form (in the ATO’s view) makes a significant difference to tax treatment. The view is that the amounts are “recurrent in nature and are not made in respect of the profit-making structure. This is an ongoing payment by the fund for trustee services, the fee for which has been increased to factor in the increased costs incurred by the trustee in providing its services.”

Our view

The distinction drawn in TD 2023/D3, based on form, appears inconsistent with the history of case law regarding the revenue/capital distinction. The distinction has been, and will probably remain, an area of much litigation due to the highly factual nature of the enquiry required. But what is clear from the case law to date is that what matters is the substance of the advantage that the payments secure rather than the form of the payment.

There is no compelling reason why payments made to compensate for additional risk arising from section 56(2) of SIS ought necessarily be capital in nature in all instances, but likewise, there could be circumstances in which they may be. Each arrangement should continue to be assessed on its own facts.

Taxation determinations express the ATO’s view only. They are not binding on taxpayers and courts can (and often do) overrule positions stated in the rulings. That noted, a greater penalty risk arises in taking a position inconsistent with the rulings (which could result in a call on the Trustee Reserve).

Therefore, trustees considering adopting positions different from those stated in the ATO ruling should seek independent tax advice based on their unique circumstances to correct characterisation and understand how to manage the penalty risk.

The ATO is inviting trustees to comment on this draft determination by 19 January 2023 on their website here.