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Two mysteries that loom large on the SMSF landscape are the issues of SMSF penalties and the sole purpose test. However, a recent Federal Court case sheds some light on the uncertainties in these areas.
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SMSF penalties and sole purpose test illuminated by the Federal Court
30 October 2014
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Facts of the case
The decision in Deputy Commissioner of Taxation (Superannuation) v Graham Family Superannuation Pty Limited [2014] FCA 1101 (‘Graham’) involved an SMSF that was established in 2006. The trustee of the fund was a company. The directors of the trustee and members of the fund were Ian and Carolyn Graham (husband and wife).
In 2007, the trustee purchased a residential property and leased it to Ian and Carolyn’s son. Rent was not paid and $60,762 was outstanding by 30 June 2012.
Additionally, from around 2007 until 30 June 2012, the trustee had paid for a caravan, stud cattle, motor vehicles, and associated costs for these items. These items did not generate income for the fund. There was also other unexplained expenditure. The various outgoings were treated as loans and by 30 June 2012, the loan account of the fund stood at $260,064. Auditor contravention reports were lodged between 2008 and 2011.
The fund was not declared non-complying at any point. The court recounted that the reason for this was that Ian and Carolyn repaid the fund using other assets. The parties agreed that the commissioner could have declared the fund to be non-complying.
The parties also agreed that the trustee of the fund contravened the sole purpose test, the prohibition on loans to members, the in-house asset rules and the arm’s length rule.
Sole purpose test
Many advisers and trustees are concerned about the sole purpose test every time a course of action involves a related party of the fund. There is an idea that the sole purpose test represents an unquantifiable risk that can be used to ‘attack’ many arrangements. However, it is notable that the language of the test does not even use the term ‘related party’. While the application of the sole purpose test can be difficult, Graham hints at what is truly behind it.
The ATO view is that the sole purpose test requires an objective assessment of the facts (SMSFR 2008/2). That is, the question is not resolved by trying to look into the actual intention a person has, but rather by examining what a reasonable observer would glean from the facts.
In Graham, the fund’s residential property was leased to a related party and rent was not collected. The sole purpose test was contravened. On the other hand, where dealings are at arm’s length, it has been observed in other decisions that the sole purpose test was not contravened (eg. AAT Case 6059 (1990) 21 ATR 3477). While language of the sole purpose test does not mention the term ‘arm’s length’, if an investment is at arm’s length, the natural objective conclusion is far more likely to be that it was done to provide retirement benefits, and is consistent with the sole purpose test. Indeed, in writing orders relating to the Graham decision, Buchanan J described that the sole purpose test was contravened by ‘providing rental accommodation on non-arm’s length terms to [Ian and Carolyn’s son]’.
Accordingly, whether the investments are at arm’s length is an extremely good indicator of whether the sole purpose test is contravened or not.
SMSF penalties
The decision in Graham discusses the ‘old’ civil penalty regime (ie. the penalty regime that requires the ATO to apply to the court in order to have the penalty imposed). This regime still exists but is diminishing in importance due to the new administrative penalty regime that commenced on 1 July 2014 (colloquially referred to as the ‘SMSF speeding fine’ rules).
In Graham, Ian was liable to pay penalties of $30,000 and Carolyn was liable for $10,000. These amounts had been agreed between the parties before the judgment. The court was required to consider whether the penalty was appropriate and whether it needed to be adjusted. The maximum penalty in the relevant law was $220,000 per contravention. Buchanan J found the agreed penalties (which were significantly lower than what could have been imposed) to be appropriate.
The relevant facts of the case occurred prior to the commencement of the new administrative penalty regime. Were these facts to occur today, the ATO may well have chosen the path of least resistance — applying administrative penalties under the new regime instead of going to court. We now consider the differences between the two approaches.
The effect of a ‘dominant’ trustee
It is interesting that Carolyn received a lower penalty since her husband was found to have played a dominant role in the management of the fund. However, trustees and advisers should not be lulled into a false sense of security that a ‘passive’ trustee will be ‘let off the hook’. The context of the Graham decision is confined to the specific law considered. The civil penalty regime involves a level of discretion as to the amount of the penalty, which allows considerations of who was the ‘dominant’ player. In contrast, the new administrative penalty regime does not contain this discretionary element. Further, other areas such as trust law do not recognise the idea of a ‘passive’ trustee (eg. In the Estate of William Just deceased (No 1) (1973) 7 SASR 508, 513). Such cases show that each trustee who accepts the office is an active trustee.
The amount of penalties and ability for ATO imposition
In Graham, excluding legal costs, the directors had to pay total penalties of $40,000. If the same contraventions occurred today, the ATO could likely impose administrative penalties of at least $20,400 (in-house assets and loans to members are penalised at 60 units each, with each unit worth $170). These penalties could be imposed relatively easily by the ATO, without needing to approach the court. Interestingly, the arm’s length rule and the sole purpose test cannot currently be penalised under the new administrative penalty regime (they are not mentioned in the statutory list).
Also, the total administrative penalty would likely be doubled in the case of two individual trustees instead of a corporate trustee.
Whether multiple similar contraventions attract one penalty or one penalty each
In Graham, there were 80 distinct contraventions of the prohibition on loans to members. However, the parties and the court accepted a single penalty being imposed on a ‘course of conduct’ basis. That is, the loan contraventions were accepted to be part of one ‘course of conduct’, and therefore attracted one penalty. However, the court in Graham was required to sanction this approach, with Buchanan J mentioning that different facts may have produced a different result. When comparing the penalty regime in Graham to the new regime, it is notable that the new regime is couched in inflexible terms as follows (SISA s 166):
If a person… contravenes a provision of this Act specified in the table, the person is liable to an administrative penalty. The amount of the penalty is the amount specified in the table for the provision.
This language does not lend itself to a ‘one penalty for a single course of conduct’ approach. Also, paradoxically, it would appear that if there are fewer contraventions, it is more likely that a penalty applies each time. For example, if there were only two loans to members, six months apart, it is hard to argue this is a ‘course of conduct’. Rather, it is more likely that each loan would give rise to its own penalty (unless the ATO specifically chose to apply the law more leniently).
The role of ATO policy in applying the new administrative penalties
The above comments on the new penalty regime should also be tempered with recent comments on ATO policy.
The ATO’s Stuart Forsyth (assistant deputy commissioner, Superannuation) has stated at the Australian Investors Association Annual National Conference (Gold Coast, Tuesday 5 August 2014):
For penalties to be imposed there will usually be an unrectified contravention or repeat contraventions that lead us to begin audit action.
…
Administration penalties will only really be a concern where there are serious contraventions. As long as trustees take care to rectify in a timely manner penalties are unlikely to be an issue. In sum, know your responsibilities, be careful with related party transactions and don’t push the rules.
In summary, the ATO has broad flexibility with the new administrative penalty regime. The new rules have the legislative wording to allow them to operate very strictly. However, non-binding statements on ATO policy suggest a more lenient approach for trustees that do not show deliberate or careless disregard for regulatory requirements.
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This article is for general information only and should not be relied upon without first seeking advice from an appropriately qualified professional.
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