SMSFs - Potential Pitfalls and Remedies

Paul Cosgrave^# and Ian Glenister^##

1. As members of SPAA would be aware, there has been in recent years a huge growth in the number and assets of self managed superannuation funds ("SMSF") in Australia. According to recently released figures from the Australian Taxation Office ("ATO"), at June 2004, there were in Australia around 300,000 funds holding assets of about $125 billion. New funds continue to be established at a rate of approximately 2,500 per month.

2. At the same time as this scenario has been evolving in the area of self managed superannuation, so too has the field of company law reform progressed, in particular, the changes associated with the introduction of the Financial Services Reform Act. This arguably constitutes the most significant development in company law of the last 20 years, including as it does a single licensing system for providers of financial services including superannuation products.

3. Since it became responsible for the regulation of SMSFs in 1999, the ATO has sought to educate accountants, financial advisers and auditors about their obligations and responsibilities under the Superannuation Industry (Supervision) Act 1993 ("SISA") and the regulations made thereunder ("SISR"). The ATO and Australian Prudential Regulation Authority ("APRA"), to the extent that the latter is responsible for other complying funds, are concerned that fund investments are in accordance with trustees' stated investment strategy and that trustees can demonstrate that they have taken into account risk, return, diversification and cashflow requirements when preparing and implementing their investment strategy. As reported in the SMSF magazine for August 2004, SMSFs are now entering the tough world of compliance and the ATO has additional staff to monitor the position. The ATO proposes to more than double the annual audit of funds to over $2000 per annum.

4. Given the change in emphasis from education to enforcement, what might the ATO discover from its audit of SMSFs? Anecdotal evidence suggests that some breaches of the statutory provisions are relatively common:

   • a fund buys an investment which provides an immediate benefit to a member or associate, thereby infringing Section 62 SISA which requires that a regulated super fund operates for the core purpose of providing benefits for members on their retirement, or for their dependants in the case of the member's death before retirement;

   • the assets of the SMSF are not kept separate from the members' personal assets thereby infringing Section 52(2)(d) SISA;

   • a business is being run from within the fund, thereby infringing the sole purpose test of Section 62 SISA;

   • the fund has lent monies or provided other financial assistance to a member or a member's relative, infringing Section 65 SISA.

5. Should one of the above situations be found, the potential consequences for the fund are very serious. Significant tax concessions are granted to complying funds as defined in Section 42A SISA. In essence, an SMSF is a complying fund if and only if:-

   
   

   (a) the trustee is a resident regulated superannuation fund;

   (b) the fund did not breach SISA or the SISR during an income year; or

   (c) the trustee contravened a provision of SISA or SISR and the ATO, having regard to the seriousness of the breach and the financial consequences of the fund becoming non-complying, decides that the fund should nevertheless be treated as complying for the applicable income year.

6. The benefit of being a complying fund is that there is a maximum tax rate of 15% on the fund's earnings and 10% on capital gains made on the disposal of an asset held for 12 months or more. Further, if the underlying assets are being used by the trustee for payment of a pension, any earnings and capital gains are tax free.

7. Should a fund become non-complying, all income and capital gains are taxed at a rate of 47%. In addition, Section 295-320 of the Income Tax Assessment Act 1997 provides that the assessable income of a non-complying fund which was previously complying, is to include the sum of the market values of the fund's assets immediately before the start of the income year in which the fund became non-complying less any undeducted contributions. So for example, if an SMSF had assets of $900,000 at the start of the income year and additional contributions of $100,000 were made during the year, if there were breaches of SISA or SISR during the income year, the fund could be liable to tax of $470,000, thereby reducing the value of the fund to $530,000.

8. What redress is available in these circumstances? There are several possibilities depending upon the particular facts .

9. First, Section 55(3) SISA provides that a person who suffers loss or damage as a result of the conduct of another person that was engaged in in contravention of sub-section (1), can recover the amount of the loss and damage by action against that other person or against any person involved in the contravention. Section 55(1) states that a person must not contravene a covenant contained, or taken to be contained, in the governing rules of a superannuation entity, such as an SMSF. Section 52 SISA effectively deems the governing rules of SMSFs to contain the various provisions set out in Section 52(2). So, for example, if the trust assets are not kept separately from the trustee's personal assets, or there is no properly formulated investment strategy, then a member can take action to recover any loss and damage suffered as a result of the contravention of the covenant. This could include action against the trustee, relevant accountant or financial adviser.

10. Division 5 of Part 21 SISA is concerned with the civil and criminal consequences of contravening civil penalty provisions. The object of this part of SISA is to specify the consequences of such contraventions. Section 193 of the Act specifies certain provisions as civil penalty provisions. This includes sections dealing with the sole purpose test, the prohibition on lending to members, the prohibition on trustees borrowing and the requirement for trustees to comply with the in-house asset rules. Section 215 SISA enables a court hearing a civil penalty proceeding to order payment of compensation in respect of loss and damage resulting from the act or omission constituting the contravention. A similar situation applies pursuant to Section 216 SISA in respect of persons found guilty of an offence constituted by a contravention of a civil penalty provision in relation to an SMSF.

11. Under Section 218 SISA, where a civil penalty provision in relation to an SMSF is contravened by a person other than the trustee, the trustee may, by proceedings in a court of competent jurisdiction, recover from that person as a debt due to the trustee:-

    
    

    (a) if that person or another person has made a profit because of the act or omission constituting the contravention, an amount equal to that profit; and

    (b) if the SMSF has suffered loss or damage as a result of that act or omission, an amount equal to that loss or damage. This applies whether or not the party against whom compensation is sought has been convicted of an offence in relation to the contravention or has had a civil penalty order made against them.

12. Apart from these provisions, there is expressly reserved by Section 219 SISA the ability to bring any other claims legally permitted to recover loss and damage. Depending upon the circumstances, this might include actions for breach of trust, breach of contract, negligence and misleading conduct.

13. Given the current climate, with so many SMSFs established, the sums of money involved and the initiative by the legislature and the regulatory authorities to improve and enforce compliance, as well as the conduct of more aggressive advisers who make empty promises like "We'll show you a legitimate way to obtain early access to your superannuation monies!", we expect there could be considerable litigation in the near future. Indeed, our experience is that this forecast trend has already begun^###.

^# Paul Cosgrave is a Melbourne based commercial barrister with a special interest in superannuation law.

^##Ian Glenister is the Principal of Glenister & Co., a specialist superannuation, wills, estate planning and business law practice. Ian is one of the first lawyers in Australia to complete the Strategist Group course with Grant Abbott to become an accredited Self Managed Superannuation Specialist Advisor under the Financial Services Reform Act. For more information, go to www.glenister.com.au. Both Paul and Ian are members of SPAA and the Strategist Group.

^###DISCLAIMER
Please note that this information should not be relied upon for decision making or providing advice without seeking expert opinion. Glenister & Co exclude all liability relating to relying on this information.