Background and context

Superannuation is a long-term vehicle for building retirement savings, and is a key element of the Australian Government's policies to address the financial independence of Australia's ageing population.

Superannuation is the largest financial asset of Australian households.¹ The level of superannuation savings has grown by 76 per cent over the last 5 years to $913.9 billion as at 30 June 2006.² This significant increase in savings has been underpinned by concessional tax treatment, including a tax rate of 15 per cent on the income of complying superannuation funds.³

For taxation purposes, superannuation funds are defined in the Superannuation Industry (Supervision) Act 1993 (SISA) to include schemes which are for the payment of superannuation benefits upon retirement or death.
a) Superannuation funds are broadly categorised into those:

• regulated by the Australian Prudential Regulation Authority (APRA):
• retail or public offer funds: offering products to the public generally;
• corporate or employer-sponsored funds: for the benefit of employees of the sponsoring entity;
• industry funds: for employees under a common industrial award or working in the industry;
• public sector funds: for the benefit of government employees; and
• small APRA funds: funds with fewer than five members which are regulated by APRA.

b) regulated by the Australian Taxation Office (Tax Office):

• self managed superannuation funds (SMSFs).

As at 30 June 2006, the Tax Office was responsible for the supervision of some 320 000 SMSFs (approximately 98 per cent of all complying superannuation funds)⁴, comprising 616 000 members⁵ (approximately 2 per cent of all superannuation member accounts⁶). Approximately one quarter (or $209.9 billion)⁷ of all superannuation savings was invested through SMSFs. In addition, an estimated $3.95 billion in tax concessions were made available to SMSFs in the 2005–06 financial year.⁸

SMSFs, or do it yourself funds, by statutory definition are superannuation funds:

• with fewer than five members (all of whom are trustees⁹);
• where no trustee of the fund receives remuneration from the fund or any persons for duties or services performed by the trustee in relation to the fund; and
• where no member is an employee of another member (unless that member is a relative).

Objective and scope

This is the first of two audit reports concerning the Tax Office's administration of SMSFs pursuant to the provisions of the Superannuation Industry (Supervision) Act 1993.

This audit report examines the efficiency and effectiveness of the Tax Office's approach to regulating and registering self managed superannuation funds. Specifically the ANAO examined the:

• environment in which SMSFs operate, including the Tax Office's regulatory roles and responsibilities;
• Tax Office's governance of its SMSF regulatory role; and
• systems, processes and controls the Tax Office uses to register SMSFs, and enforce the lodgement of fund income tax and regulatory returns.

The second audit report, scheduled for tabling in the first quarter of 2007–08, will examine the efficiency and effectiveness of the Tax Office's approach to managing self managed superannuation fund compliance risks. Specifically the ANAO will examine the processes the Tax Office uses to:

• identify the risks relevant to SMSFs not complying with their obligations under the SISA, including members accessing their superannuation early;
• mitigate SMSF compliance risks; and
• wind-up funds.

Overall conclusion

The decision to transfer the regulation of SMSFs from APRA presented the Tax Office with a number of challenges. In 1999–2000 the Tax Office inherited responsibility for an unfamiliar regulatory role covering a sector of the superannuation industry that was at the time suspected of having high levels of non compliance. The SMSF sector consisted of approximately 187 000 funds, which were growing at a rate of 470 funds each week, but which had not received close supervision by their previous regulators.

In addition, the Tax Office was given the responsibility for administering SMSFs when it was implementing A New Tax System, and was asked to absorb a large proportion of the costs applicable to regulating SMSFs.

Overall, the ANAO concluded the Tax Office's initial approach to regulating and registering SMSFs could have been more efficient and effective. In particular, the Tax Office could have taken steps to clarify its role and responsibilities earlier, managed its funding, costs and revenue (levy) collections more effectively, and, improved the collection and assessment of registration data, and fund income tax and regulatory return data, prior to issuing SMSFs with complying fund status. In this context, it is important that members and potential members understand the limited extent of the Tax Office's prudential supervision of SMSFs.

The ANAO recognises that, since 2003–04, the Tax Office has initiated significant steps to resolve deficiencies with the administrative and costing systems that support its regulation and registration of SMSFs. The Tax Office intends to make further changes to its SMSF management practices in implementing the Simplification Superannuation reforms. Further, the Tax Office is in the process of developing a new publication which will assist to clarify its role and responsibilities for the public.

The introduction of the Simplification Superannuation reforms may further increase the attractiveness of SMSFs as a retirement savings vehicle, resulting in a continuing need for the Tax Office to focus its attention on SMSF intelligence gathering and data deficiencies if it is to effectively carry out its responsibilities under the SISA.

Key findings

Background and context (Chapter 1)

There are two principal legislative instruments that define the obligations of superannuation fund trustees. These are the: SISA and Superannuation Industry (Supervision) Regulations 1994 (SIS Regulations).¹⁰

Three Australian Government agencies are responsible for administering the SISA and the SIS Regulations: APRA, the Australian Securities and Investment Commission (ASIC) and the Tax Office. To provide assurance the superannuation industry is properly regulated it is important that there is effective coordination between the three regulators.

The role of the Tax Office in regulating SMSFs is determined by both general requirements applicable to all superannuation funds and specific SMSF requirements as set out in the SISA and the SIS Regulations.¹¹

Growth in self managed superannuation funds

Since 1999–2000, the number and value of SMSFs has increased considerably. From 2000–01 to 2005–06, the number of SMSFs increased by some 109 000 (a 52 per cent increase). Over the same period, the value of SMSF assets was estimated to have increased by approximately $132 billion (a 169 per cent increase).

Recent developments in the administration of self managed superannuation funds

The Government has recently initiated significant changes that will assist the Tax Office to administer SMSFs and to simplify applicable administrative functions for SMSF trustees. On 15 March 2007, the Tax Laws Amendment (Simplified Superannuation) Act 2007 and related legislation received Royal Assent. Changes introduced by the amending legislation include:

• streamlined reporting requirements;
• the introduction of a trustee declaration form to ensure that new trustees, or directors of corporate trustees, understand their duties as trustee of a SMSF;
• new administrative penalties for late returns and false statements; and
• increases in the superannuation supervisory levy from $45 to $150 to recover the Tax Office's regulatory costs.

These changes will generally apply from 1 July 2007. The Tax Office advised that some of the recommendations in this report will be satisfied by changes it is proposing to make as part of implementation of the Simplification Superannuation legislation.

The Tax Office's self managed superannuation fund role and responsibilities (Chapter 2)

To provide the Parliament and the public with assurance the Tax Office is fulfilling its role as the SMSF regulator, it is important the role of the Tax Office is defined clearly and conveyed publicly, and that the Tax Office reports the actions it undertakes to discharge its role.

When the Tax Office was given responsibility for regulating SMSFs in 1999–2000, the Government specified that the Tax Office was to ensure that SMSFs complied with the non-prudential requirements of the superannuation law. Following changes made to the SISA in 2004, the Tax Office sought legal advice to clarify whether its regulatory role encompassed any prudential supervisory responsibilities. This advice indicated that the SISA does not make it clear whether or not the Commissioner of Taxation has a prudential supervisory function. The Tax Office was advised that legislative amendment to the SISA and or SIS Regulations would assist in clarifying the Government's policy intent regarding the Tax Office's interpretation of its prudential supervisory responsibilities.

Subsequently, the Tax Office approached the Treasury in 2004–05 and in 2005–06 to clarify whether it had a prudential role under the SISA. Following consultation with the Treasury, the Tax Office determined that although there are a number of provisions of the SISA that have a ‘prudential flavour', its role does not extend to reviewing or commenting on specific investment strategies prepared by SMSF trustees, or whether SMSFs are financially sound.

The Tax Office's position and hence operating approach to investment strategies, is influenced by the large number of funds it regulates and as such differs to APRA's approach. APRA considers they have a responsibility for ensuring trustees' have properly formulated their investment strategies as set out in trustee documentation and that this can be demonstrated through practical implementation. Where an investment strategy or the investments appear to be significantly inappropriate, APRA advised it would work with trustees to ensure an appropriate strategy was formulated, and, where required, would consider legislative options under the SISA to ensure the situation was remedied, including disqualification of the trustees.

The Tax Office's approach is, however, consistent with past Tax Office practice and the Government's original policy intent. This intent specified that whilst SMSFs are a key vehicle in the accumulation of retirement savings, they do not require onerous prudential supervision as members should be able to protect their own interests.

The process the Tax Office undertook to clarify its role and responsibilities was useful in providing additional clarity regarding its regulation of SMSFs. Notwithstanding this, in order to provide legislative clarity of the Tax Office's role and thus support the current interpretation of its prudential supervisory responsibilities, the ANAO considers the Tax Office should consult with the Treasury in due course to assess the benefits of further refining the SISA.

As noted, this sector of the superannuation industry accounts for approximately one quarter of all superannuation savings. Notwithstanding the potential impact of Simplification Superannuation amendments, it is important that members and potential members of SMSFs understand the limited extent of the Tax Office's prudential supervision of these funds.

The Tax Office advised that it is in the process of developing a new publication which will assist to clarify its role and responsibilities for the public. The ANAO considers that over time the Tax Office should also enhance its wide range of existing SMSF documentation to be consistent with the new publication.

The coordination between the Tax Office and the Treasury regarding the timely identification and resolution of issues relating to the interpretation and application of legislative requirements is an important element of the effective regulation of SMSFs by the Australian Government. Examples such as the extent of the Tax Office's prudential responsibilities and the treatment of instalment warrant products as legitimate SMSF investments have been identified by the Tax Office as requiring clarification by the Government.¹²

The ANAO acknowledges the steps taken by the Tax Office, as part of its review of SMSFs in late 2005, to resolve such issues. However, the ANAO considers, especially in regard to the treatment of instalment warrants, the Tax Office could have established its position on this issue sooner, which may have led to a more timely resolution, and minimised the potential for public uncertainty.

As the Tax Office's SMSF intelligence capability develops, it should have a continuing focus on risks posed by emerging investment products, especially those targeted at SMSFs. Clearly defined processes and procedures should be in place to enable the Tax Office to identify and advise the Treasury, and the Government generally on a timely basis, of key risks to the effective operation of relevant superannuation legislation. Where required, the Tax Office should develop and promulgate relevant educational material relating to products utilised by SMSFs.

Other aspects of the Tax Office governance of the self managed superannuation fund regulatory function (Chapter 3)

An important aspect of managing the effective allocation of the Tax Office's finite SMSF regulatory resources is to identify which administrative functions are required and, given all SMSFs pay a supervisory levy which is intended to recover the Tax Office's costs, to cost these functions appropriately. The Tax Office did not have adequate systems in place between 1999–2000 and 2002–03 to record budgets or actual expenditure for SMSF regulation. It has significantly changed the methodology it uses to determine its expenditure and develop its budgets from 2003–04 to 2005–06.

A key aspect of funding the regulation of the superannuation industry is that the costs of regulation should be borne by those who benefit from it.¹³ In the case of SMSFs, the costs should be borne by the funds' trustees. Through the Superannuation (Self Managed Superannuation Fund) Supervisory Levy Imposition Act 1991, a $45 levy (per fund per annum) was introduced, to cover the Tax Office's regulatory costs.

However, since the levy was introduced in 1999–2000, there are a number of indicators that the levy has not been operating on a cost recovery basis. Specifically, the expenditure on SMSF regulatory activities has never been commensurate with levy revenue; the levy is not tied to the Tax Office's funding base; the Tax Office has not complied with reporting requirements set out in the Australian Government Cost Recovery Guidelines for cost recovered revenues; the absence of an effective cost allocation system has inhibited the Tax Office's capacity to accurately determine its regulatory costs; and, the levy rate has not been adjusted despite changes in the cost of regulation.

On 5 September 2006, the Government announced the levy rate will be increased to $150 per fund per annum to cover the increased costs of SMSF regulation. The explanatory memorandum to the Simplification Superannuation legislation confirms the revised levy is to recover costs. The ANAO considers that, for the Tax Office to fulfil its obligations, it should undertake steps to; determine if the levy will operate on a partial or full cost recovery basis and develop arrangements with the Treasury to regularly review the levy rate; develop and implement procedures to collect un remitted levy payments from SMSF trustees; and report publicly on the cost of SMSF regulation and the revenue collected through the levy.

The ANAO examined the Tax Office's interaction with other superannuation regulators. On the whole, the Tax Office's relationship with the other regulators appears to be working well. The ANAO noted the Memorandum of Understanding between the Tax Office and APRA had lapsed in 2003 and was only updated in May 2007.

Since the introduction of SMSFs, the Tax Office has worked to foster a constructive relationship with the superannuation industry and other stakeholders. Based on the interviews with SMSF stakeholders¹⁴, the ANAO considers that, overall, the Tax Office's relationship with these stakeholders is sound.

Important elements of robust governance are effective corporate and business planning, risk management and reporting processes which provide assurance that all corporate objectives and planning documentation are aligned and mutually supportive.

The Tax Office's business planning, risk management and reporting processes generally are sound. However, the ANAO considers that the Tax Office needs to improve the quality of the SMSF data collected from its systems to ensure business decision making processes are robust. The Tax Office advised it is in the process of improving the quality of the data, and the intelligence it derives from that data.

There are large numbers of SMSF trustees that do not lodge their fund income tax and regulatory returns on time, or at all.¹⁵ For this reason, the Tax Office derives an estimate of SMSF assets using return forms that have been lodged. The ANAO considers the reliability of the Tax Office methodology for estimating SMSF assets could be improved by incorporating ‘inactive funds' information currently recorded on other Tax Office systems and by comparing original estimates with actual lodgement data when this becomes available.

The Tax Office advised it is introducing a lodgement program in 2007–08 which aims to improve the lodgement time of fund income tax and regulatory returns from 70 to 94 per cent within 6 months of the due date. If effective, this initiative should also improve the quality of SMSF statistical information released publicly.

Registering self managed superannuation funds and issuing notices of compliance

For a fund to be a complying fund the SISA states that two distinct events must occur. First, a fund must elect to be a regulated fund¹⁶ within 60 days after establishment through lodgement of an approved registration form with the Tax Office. Second, the Tax Office must issue a notice of compliance¹⁷, to notify fund trustees their fund is a complying superannuation fund.¹⁸ Without these two events occurring, a fund is not entitled to tax concessions¹⁹ and any superannuation contributions made to the fund by an employer may be subject to additional charges.

The ANAO's analysis of SMSF data indicates that a small but consistent proportion of SMSFs registered by the Tax Office do not appear to have met some basic SISA requirements such as the number of members allowed in a SMSF, that there are assets (of at least $1) set aside for the benefit of members and that the SMSF reasonably complies with the SISA requirement to lodge a registration form within 60 days of establishment.

Since January 2004, the Tax Office has been analysing information contained on superannuation fund registration forms to determine whether new funds comply with their registration requirements. At the time of the audit, the Tax Office compiled and analysed this information on an industry wide level, but did not use it to assess whether individual funds are complying with the SISA requirements in making a decision on whether to ‘register' the fund.

The current Tax Office approach to issuing notices of compliance, coupled with indicative high-levels of non-compliance by SMSF trustees, does not provide adequate assurance that SMSFs are fully complying with the SISA requirements when issued with notices of compliance by the Tax Office.

The ANAO recognises the Tax Office must use a risk-based approach to identify potentially non-complying funds, as it is not an efficient or effective to examine all new fund returns to determine whether they should receive notices of compliance. However, to enhance its SMSF compliance assessment process, the Tax Office could better utilise intelligence obtained at the point of registration to assess individual SMSF compliance with their SISA responsibilities prior to issuing the notice of compliance up to 18 months after initial registration.

Similarly, under the SISA it is illegal for a disqualified person to knowingly act as a trustee of a SMSF (or any other fund). To date, the Tax Office, ASIC and APRA do not have a central register of all disqualified persons. Such a register would, ideally, complement recent changes to the SMSF registration form and minimise the likelihood that disqualified persons can act as SMSF trustees.

The Register of Complying Superannuation Funds (RoCS) is a publicly available list of complying funds. RoCS is an important control mechanism to provide increased levels of assurance that transfers of superannuation assets and contributions are only made to complying superannuation funds.

The Tax Office advised, during the audit, that it had commenced work to implement a number of changes to improve the operation of RoCS including: allowing the public real-time access to RoCS information; increasing the amount of information contained on RoCS including the type of fund registered and whether funds have received a notice of compliance; providing warnings about illegitimate funds or schemes; and improving the RoCS search engine capability.

Recommendations

The ANAO made six recommendations aimed at improving the Tax Office's approach to regulating and registering SMSFs. The Tax Office agreed to all of the six recommendations made.

Summary of Tax Office's response

The Tax Office welcomes this review and considers the report is supportive of the Tax Office's overall direction in enhancing its administration of SMSFs. It is pleased that the ANAO report concluded that the Tax Office has initiated significant improvements to the administrative and costing systems that support its regulation and registration of SMSFs; as well as noting the further changes to SMSF management practices in implementing the simpler super reforms.

The Tax Office agrees with the six recommendations contained in the report. It is already making progress to address some of the recommendations but notes that some will take time to complete given the need to implement and bed down the simpler super measure and the redevelopment of the Tax Office's business system.

Footnotes

1 The average balance of superannuation funds was $63 000 per household across all households in 2003–04. Nearly 75 per cent of households have some superannuation assets. See Australian Bureau of Statistics, April 2006, Household Wealth And Wealth Distribution, Australia, 2003–04, p. 3.

2 Australian Prudential Regulation Authority, Statistics—Quarterly Superannuation Performance, June 2006, p. 5.

3 A complying superannuation fund is defined under section 42 of the Superannuation Industry (Supervision) Act 1993. Complying superannuation funds are taxed under the Income Tax Assessment Act 1936 Part IX.

4 Australian Prudential Regulation Authority, op. cit. p. 7.

5 Commissioner of Taxation, Annual Report 2005–06, p. 180.

6 As at 30 June 2006 there were some 28.9 million superannuation member accounts in Australia.

7 Australian Prudential Regulation Authority, loc. cit. p. 7.

8 Tax Office data from its Revenue Analysis Branch.

9 Unless, for example, the member is subject to a legal disability (subsection 17A(3) of the SISA).

10 SMSFs must also comply with general trust law, as well as legislation such as State and Territory Trustee Acts, the Corporations Act 2001, the Income Tax Assessment Acts, the Surcharge Acts, the Superannuation Guarantee Acts and the Family Law Act 1975.

11 Section 6 of the SISA specifies which provisions of the SISA are relevant to each regulator. There are a number of provisions of the SISA that are common to some or all of the regulators.

12 An instalment warrant is a derivative based product where investors are able to purchase assets in two payments: one payment upfront, generally representing 50 percent of the purchase price and one payment during the end of a defined period which includes interest and fee costs.

13 For discussion about the funding of regulatory services see S. Wallis, March 1997, Financial System Inquiry Final Report, p. 532.

14 The ANAO spoke to the following organisations during the audit: Institute of Chartered Accountants Australia (ICAA); CPA Australia Ltd; National Tax and Accountants' Association Ltd. (NTAA); Association of Superannuation Funds of Australia Ltd. (ASFA); Investment and Financial Services Association (IFSA); Australian Association of Independent Retirees (AIR); and Self Managed Super Fund Professionals Association (SPAA).

15 In the 2004–05 year, approximately 30 per cent of SMSFs did not lodge their income tax and regulatory return on time. Approximately eight per cent of SMSFs have never lodged a return.

16 Paragraph 42(1AA) of the SISA.

17 Sections 40 and 41 of the SISA.

18 This occurs after the registered SMSF has lodged its first fund income tax and regulatory return.

19 Tax concessions are received under subsection 26(1) of the Income Tax Rates Act 1986.