Self-managed super funds on notice

Self-managed superannuation funds (SMSFs), often referred to as DIY super funds, have grown rapidly in recent years. They give fund owners increased control over what happens to their superannuation, but there are a myriad of laws and regulations to comply with.

As I mentioned last year, the key regulator of the sector, the Tax Office, has been increasingly flagging its concerns about compliance by SMSFs. Auditing of SMSFs is high on the ATO’s radar.

The ATO says it usually finds that the non-compliance relates to some form of transaction or dealing with a related party. For example, despite there being a clear prohibition on lending or providing financial assistance to fund members or relatives, this remains the most commonly reported contravention of the law. And non-compliance has serious consequences for the fund, like being taxed at 45% instead of 15%!

Recent AAT case

A recent case before the Administrative Appeals Tribunal (AAT) has graphically highlighted the sorts of problems that can arise. SMEs with self-managed super funds would do well to take note of this case.

In the case, the AAT upheld a non-compliance notice issued by the ATO to the trustee of a SMSF for regulatory breaches in respect of non-commercial loans made to a member via a linked unit trust.

A corporate trustee of an SMSF had husband and wife directors. The husband operated a legal practice and his wife is a medical practitioner. The fund was established on May 22, 1997 and has operated as a SMSF since October 8, 1999. It was accepted as a “complying superannuation fund” by the Tax Commissioner for a number of years and as such enjoyed certain tax benefits available under the tax legislation, eg. being taxed at only 15%. Funds that are found to be non-complying are taxed at 45%, so that alone is a major incentive for funds to make sure they are complying.

In July 1997, the fund invested in a linked unit trust which owned two properties at Ashtonfield in NSW. The husband said that losses incurred as a result of actions by the practice manager of his legal practice and a decline in his business through poor health, left he and his wife in a “precarious financial state” by the end of 1998.

As a result, the unit trust properties were sold for $438,000 in 2004. The proceeds (in part) were used for the fund members’ own benefit to reduce personal loans (which had been secured against the properties) and to fund the husband’s legal practice. The transaction and resulting loan to the fund member were not documented, they were not on commercial terms and no interest was paid. At June 30, 2005, the only asset of the unit trust was a loan to the husband for $190,411.

Between July and September 2008, the Commissioner commenced audits of the fund for compliance with the Superannuation Industry (Supervision) Act 1993 (the SIS Act) for the years ended June 30, 2005 and June 30, 2006. Those audits were completed in July 2009. The Commissioner formed the view the fund trustee had not complied with the regulatory provisions and on December 14, 2009 issued a notice of non-compliance for the year ended June 30, 2005.

Contravention of laws

The non-compliance notice was issued for contravention of certain regulatory provisions of the SIS Act, that is, failing the sole purpose test, the provisions concerning indirect financial assistance and the non-arm’s length investment rules. The fund’s non-complying status resulted in a tax liability of $92,348.

The trustee is the trustee of both the SMSF and the unit trust for the properties that had been purchased. The Commissioner argued that the trustee, by allowing the investment in the properties unit trust and failing to ensure any income was received:

• failed to ensure the fund was maintained for the sole purpose of providing retirement benefits to the members in breach of s 62(1) of the SIS Act;
• provided indirect financial assistance to the husband and wife directors and related entities, in breach of s 65(1)(b) of the SIS Act, and
• made investments in a related party without ensuring the related party investments were made on commercial terms and on an arm’s length basis, in breach of s 109(1) of the SIS Act.

The fund trustee sought a review of the Commissioner’s decision not to exercise his discretion to treat the fund as a complying fund despite the contraventions. The trustee submitted that the Commissioner should instead accept an enforceable undertaking for it to rectify the breach, as it would not be in the best interests of the fund members to impose a tax liability of $92,348.

However, the Commissioner noted that the undertaking proposed by the taxpayer depended on the ability of the unit trust to recover a substantial debt from the husband and, in any event, would not restore the fund to its correct position.

The AAT upheld the Commissioner’s decision not to exercise his discretion to treat the fund as a complying fund despite the contraventions. The AAT considered the contraventions were “serious” and that the impact on the fund had been “significant”.

The husband said the contraventions were inadvertent and based on a lack of understanding about self-managed superannuation funds and the roles and responsibilities of trustees.

However, the AAT said the evidence raised some serious concerns. It said the wife did not know she was a director of the trustee and did not know the investment properties at Ashtonfield were assets of the properties unit trust.

The husband gave evidence that in 2004, he did not consider the question of whether selling the Ashtonfield properties would affect the value of the fund and did not understand the purpose of the properties unit trust.

Directors’ duties cannot be delegated

The AAT accepted that the husband and wife, as directors of the trustee, did not understand these were contraventions of the SIS Act because they lacked experience in this area. On the other hand, they did not seek advice or adequately inform themselves about the role of a trustee of a self-managed super fund and relied on their accountants.

However, the AAT said the duties of a director cannot be delegated to advisers. While the AAT said it may be appropriate for a director to rely on the advice of others, directors must make their own enquiries and independent assessment of that information or advice. This is an important and timely reminder for SMEs.

While the Tax Commissioner acknowledged that the ATO does have a role in educating taxpayers and trustees of SMSFs about taxation and superannuation laws, SMEs should note that the AAT said the ATO does not have an obligation to ensure trustees understand and comply with the law. In the AAT’s view, the primary responsibility for this obligation resides with trustees, and if the trustee is a corporate trustee, those who manage them.

The AAT accepted that the tax consequences of the non-compliance notice were significant but said they did not outweigh the seriousness of the contraventions which went to the heart of prudential regulation of SMSFs. The AAT noted that the related party dealings were not documented, provided no security and no attempt had been made by the fund member to repay the loan or pay interest since 2005.

The AAT also upheld the Commissioner’s decision not to accept an enforceable undertaking as an alternative to the notice of non-compliance. The AAT said that a key principle that underlies the exercise of discretion to accept an enforceable undertaking is that action should be taken to rectify the contraventions and to ensure breaches are not repeated. However, the AAT considered that the undertaking proposed by the trustee did not seek to rectify the contraventions or put the fund in the position it should have been in but for the contraventions.

An important reminder

This case is an important reminder for those who set up SMSFs to be aware of the laws that govern them.

Terry Hayes is the senior tax writer at Thomson Reuters, a leading Australian provider of tax, accounting and legal information solutions .

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