Bryce Figot says taking prompt action to fix a breach of the rules can make it more a near-death experience than a terminal blunder.
A recent Administrative Appeals Tribunal decision provides valuable guidance and timely reminders for SMSF trustees and their advisers. The decision is especially relevant for those SMSF trustees that have contravened the SIS rules and are concerned about non-compliance. This article summarises the decision and its key lessons.
The decision is ZDDD v Commissioner of Taxation [2011] AATA 3 and its full text can be found at www.austlii.edu.au/au/cases/cth/AATA/2011/3.html
Summary of the decision
Mr K was a lawyer and his wife, Dr K, was a general practitioner. In May 1997 an SMSF was established. At all times Mr and Dr K were the SMSF’s only members and the only directors of its corporate trustee. In July 1997 the SMSF trustee acquired units in a related unit trust. At all times the only assets of the SMSF were units in the unit trust. The unit trust trustee acquired several properties.
Mr K had his own law firm and employed a practice manager. In 1998 Mr K discovered discrepancies in his accounts, which resulted in the practice manager being charged with fraud-related offences. Mr K suffered business losses due to the actions of the practice manager and also due to his poor health. Consequentially, during the 2005 financial year, Mr and Dr K were under significant financial pressure. They had four dependent children and risked losing their family home. The unit trust trustee sold its properties and used the proceeds to pay debtors of the law firm and Mr and Dr K personally. The accounts of the unit trust treated this as being a loan to Mr K of $190,411. The loan was undocumented and unsecured, and no interest was accrued or paid. The unit trust trustee also made or received several loans from Mr K, the family trust trustee and Mr K’s law firm. None of these loans were on commercial terms.
‘However, where a contravention does occur, it should be taken extremely seriously’
Neither Mr nor Dr K lived an extravagant lifestyle. Neither Mr nor Dr K had much knowledge about the roles of directors of an SMSF trustee.
In 2008, the Commissioner audited the SMSF. The loan to Mr K was still in place and no interest or repayments had been received. The Commissioner considered the SMSF trustee’s actions in allowing the investment in the unit trust and failing to ensure any income was received. He formed the view that these actions contravened three important SIS rules, namely:
• the “sole purpose” test;
• the prohibition on the provision of financial assistance to fund members and their relatives; and
• the prohibition on investing with related parties on a non-arm’s length basis.
The SMSF trustee does not appear to have contested this view.
In July 2009 the Commissioner advised that unless the trustee rectified the contraventions, he might make the SMSF non-complying. Mr K offered to put a loan agreement in place and pay interest. He proposed that the interest be calculated on an “interest only” basis and commence accruing only from July 2009. Rather than repaying the principal of the loan with cash, Mr K offered to take a non-cash lump sum when he attained age 55 (in July 2011), essentially consisting of units in the unit trust.
The Commissioner considered that this was “not sufficient to rectify the longstanding contraventions that have occurred”. Accordingly, in December 2009, the Commissioner issued a notice of non-compliance.
In January 2010 the SMSF trustee offered to enter into an unenforceable undertaking “to take whatever steps [the Commissioner] feel[s] appropriate to rectify the breach over time”. In October 2010 a formal enforceable undertaking was offered to the Commissioner with specific undertakings (for example, an interest rate of 7.5 per cent and monthly repayments of $1811).
However, the Commissioner refused to withdraw the notice.
The SMSF trustee applied to the AAT to review the Commissioner’s decision to refuse to withdraw the notice. The SMSF trustee also asked the AAT to review the Commissioner’s decision to refuse to accept the enforceable undertaking.
The AAT affirmed the Commissioner’s decisions.
Prompt action to fix contraventions
Nowhere in the decision was it suggested that merely contravening SIS rules automatically leads to a notice of non-compliance.
Where contraventions of the SIS rules have occurred, the Commissioner has discretion as to whether to make the SMSF non-complying. The legislation requires that the Commissioner considers the following three elements in exercising this discretion:
• the taxation consequences of non-compliance;
• the seriousness of the contravention or contraventions; and
• all other relevant circumstances.
The AAT acknowledged that the taxation consequences of non-compliance could be serious and could possibly result in the SMSF becoming insolvent. However, it was not convinced that the tax consequences of the notice of non-compliance outweighed other factors, including the seriousness of the contravention.
The AAT formed the view that the nature and extent of the contraventions were serious and militated against issuing a notice of compliance.
Although not expressly stated, two key elements seemed to go the heart of seriousness:
• money had left the superannuation environment; and
• the problem had been left to fester.
Accordingly, where an SMSF trustee does contravene a SIS rule, the contravention should be rectified immediately. Any SMSF trustee who fails to immediately rectify should be sternly warned that by failing to rectify they are implicitly heading down the path to non-compliance and will have only themselves to blame.
Where the contravention involves money leaving the superannuation environment, the contravention should be rectified by returning the money. Ideally the money should be returned on an arm’s length basis (for example, with an appropriate amount of interest).
Not an in-house asset
There was no suggestion that the SMSF trustee’s investment in the unit trust was an in-house asset. Usually, an investment in a related trust is an in-house asset. Only 5 per cent of an SMSF’s assets may be comprised of in-house assets. However, investments in unit trusts made prior to 1999 are typically excepted from constituting in-house assets.
This was the case in ZDDD: although the SMSF trustee had invested in what appears to be a related trust, because it was made prior to 1999, the investment was probably not an in-house asset. Accordingly, there was no suggestion that the SMSF trustee contravened the in-house asset rules.
Indirect actions led to the non-compliance
The ZDDD decision serves as an important reminder: just because a unit trust is a “pre-’99” unit trust, does not mean its trustee can do whatever it likes. Where an SMSF trustee is the unit-holder, the SMSF trustee still must justify its investment in the unit trust with respect to the sole purpose test and all the other relevant SIS rules. As occurred in ZDDD, if the unit trust trustee is using its moneys for purposes other than legitimate investment purposes, the SMSF trustee might find itself having to explain to the Commissioner why it continues to hold investments in the unit trust.
Interest rate
There was some discussion as to what the appropriate interest rate was in respect of the loan to Mr K. The Commissioner said the appropriate interest rate was the Division 7A interest rate (that is, the Indicator Lending Rates – Bank variable housing loans interest rate last published by the Reserve Bank of Australia before the start of the year of income). This is good news for taxpayers because the Division 7A rate may be significantly lower than the arm’s length interest rate. An unsecured interest rate offered by banks for, say, a credit card is currently between 13.5 per cent and 21 per cent. The Division 7A interest rate is currently 7.40 per cent. Naturally, it would be a lot easier for a borrower to pay back a loan with a 7.40 per cent interest rate than a loan with an interest rate ranging from 13.5 per cent to 21 per cent. Of course, this is not to say that the appropriate interest rate on all loans involving SMSFs is always the Division 7A interest rate.
ZDDD reminds us that contravening a SIS rule is not necessarily fatal. However, where a contravention does occur, it should be taken extremely seriously and rectified as soon as possible.
Bryce Figot is a senior associate at SMSF law firm DBA Lawyers – www.dbalawyers.com.au
