April 14, 2014

Imposing penalties on SMSF’s – ATO powers extended

Like all regulated superannuation funds, Self Managed Superannuation Funds (SMSFs) are eligible for significant taxation concessions. Most classes of income are taxed at 15%, discount capital gains at 10%, and 0% to the extent the fund is paying pensions to members.

To be eligible for these concessions, the SMSF must comply with a number of conditions.

This article focuses on some of the consequences that can arise from a contravention of one or more of these conditions.

ATO move from education to enforcement

In 1999, the ATO took over administration of SMSFs. Initially, the focus of the ATO was on education, educating trustees how the rules relating to SMSFs apply. Over the last 5 to 10 years, the ATO has publicly stated that its focus has moved from education to compliance and enforcement.

Applying the conditions which will qualify an SMSF as a complying superannuation fund has created a difference in opinion between taxation advisors, and raises the question – where is the yellow line drawn? The difficulty for the ATO has been the drastic (and potentially unwarranted) measures for minor breaches. When the ATO considers that a breach has occurred, it may:

  1. make a determination that the SMSF is noncomplying. As a consequence of this determination, the balance in the SMSF (excluding undeducted contributions) is subject to tax at the top marginal rate (45%), and the income of the fund in the year it is classified as noncomplying and subsequent years until it again satisfies the conditions, again at the top marginal rate;
  2. obtain a civil penalty order, which requires an application to be made to the Court;
  3. accept an enforceable undertaking in relation to a contravention, which requires the contravening party to agree to provide the undertaking; or
  4. disqualify the trustee of the SMSF.

Example Scenario

David is the sole member of his SMSF. On 1 July 2011, his member balance is $1 million, comprised exclusively of deductible contributions and investment earnings. David’s company, David Carpentry Pty Ltd, is in need of $50,000 to finance equipment required for its business. David is aware the superannuation conditions prohibit the lending of money to a member or relative. The advice he receives is this condition does not apply where the loan is made to a company controlled by a member or relative. Rather, a loan to such a company falls within the limitation against in-house assets, which allows in-house assets provided they do not exceed 5% of the assets of the fund calculated on a market value basis. Based on the member balance at 1 July 2011, David calculates that he is able to make a loan of $50,000 to his company. On 1 October 2011, David’s SMSF makes a loan to David Carpentry Pty Ltd in the amount of $50,000. The majority of the assets of the SMSF are invested in managed funds. During the quarter ended 31 March 2012 the managed funds suffer a downturn in value by $100,000. The downturn in value is maintained from that time until after 30 June 2013. As a result of the fall in value, the loan to David Carpentry Pty Ltd has exceeded the in-house asset threshold by $5,000.

Where an SMSF acquires an in-house asset (in this case by making the loan) whicht at the time of the acquisition is within the threshold, but subsequently the in-house asset exceeds the threshold due to other events (in this case the downturn in the value of the managed funds), the SMSF is required by Section 82 of the Superannuation Industry (Supervision) Act 1993 to prepare a written plan to rectify the breach by the end of the next year of income (that is, by 30 June 2013). In this case, the SMSF does not prepare a written plan or rectify the breach.

In this scenario, the main option for the ATO is to determine the fund as noncomplying. This will have the effect of imposing a tax liability of $405,000 (45% of $900,000) for exceeding the in-house assets threshold by $5,000 (clearly an inappropriate result).

New Regime

On 18 March 2014, the Tax and Superannuation Laws Amendment (2014 Measures No 1) Act 2014 received Royal Assent. This legislation introduces a number of tools that the ATO can use to address contraventions, namely power to:

  1. give a direction to rectify a contravention (rectification direction);
  2. give a direction for the trustee to undertake a course of study (education direction); and
  3. impose a penalty under a graduated penalty regime.

The graduated penalty regime sets out various penalties for certain contraventions. For example:

Contravention  Penalty  Amount
 Failure to keep financial statements  20 penalty units $3,400
 Borrowing not permitted  60 penalty units $10,200
 In-house asset rules  60 penalty units $10,200
 Failure to keep trustee minutes for 10 years  10 penalty units $1,700
 Failure to complete survey form  Five penalty units $850

The ATO may remit (reduce) a penalty in accordance with the Taxation Administration Act 1953 where the circumstances justify it.

Takeaways

  1.  SMSFs must satisfy a number of conditions in order to qualify for the taxation concessions that apply.
  2. Previously, a minor breach of the rules exposed the SMSF to a drastic penalty if the ATO imposed non-complying status on the fund.
  3. The new rules allow the ATO to impose a penalty appropriate to the breach. In future, it is unlikely that funds will be made noncomplying other than for the most serious breaches.