Tag Archives: SMSF

Should our SMSF have kept its Principal Employer?

MissingPiece

Last month’s piece Lost SMSF trust deed replacement deeds – are they a scam? is my exposé of SMSF (self managed superannuation fund) trust deed variation techniques revealed as dodgy in the light of high Australian legal authority there set out.

So my exposé can be better appreciated and understood: this month I turn to some typical dilemmas faced by a SMSF trustee trying to update SMSF trust terms to:

  • keep them up to date with changing superannuation and tax laws; and
  • introduce capabilities so that opportunities presented by current regimes impacting superannuation funds can be effectively used.

To bring in the new, keep the old

One can see from my exposé that, to introduce new SMSF trust terms to a SMSF, a trustee needs to paradoxically keep the old.

Possibly no starker reminder of this are older SMSFs where the power of vary trust terms in the original trust deed (OTD) unconditionally requires the Principal Employer (or the “Employer” or the “Founding Employer”  – descriptions of this substantially similar role from the days of employer-sponsored superannuation vary) to initiate or consent to update trust terms of the SMSF.

My exposé further explains:

  • aside from in the narrowest of exceptions, a valid deed to vary SMSF trust terms requires a rigid adherence to the requirements of the power to vary trust terms contained in the OTD of the SMSF; and
  • an update or change to the power to vary in a SMSF OTD made on a misunderstanding that the power to vary allows amendment of the power to vary itself, when it doesn’t, is ineffective.

Invalid replacement of the power to vary

Say:

On that misunderstanding by a deed provider (unfortunately I can’t say deed lawyer here because, due to regulatory failings, SMSF legal documents with these errors are often supplied by non-lawyer outfits these days), the deed provider supplies a deed to vary SMSF trust terms by which the trustee purports to replace, among other trust terms, the power to vary in the OTD which power is replaced with the deed provider’s own contemporary take on an apt power to vary.

The SMSF trustee then considers the “replaced” power to vary which no longer requires the trustee to:

  • obtain the consent of the Principal Employer to vary trust terms; or
  • to take direction on the varied trust terms from the Principal Employer;

and decides that the redundant office of Principal Employer, no longer necessary with the evolution from employer-sponsored superannuation to self managed superannuation, can cease. The Principal Employer, say a company, is then de-registered and the office of Principal Employer under the SMSF lapses.

Marooned without a Principal Employer

As the “replaced” power to vary is of no effect this leaves the trustee unable to vary the SMSF trust terms further in future where there is no Principal Employer who can act under the power to vary from the OTD of the SMSF.

A question also arises whether the deed inserting the “replaced” power to vary also fails in its entirety where it contains an invalid replacement of the power to vary in the OTD. The answer to that question may vary case to case.

One can be more certain that deeds purporting to vary SMSF trust terms non-compliant with the power to vary in the OTD unconditionally requiring the consent etc. of the Principal Employer, will fail.

Other dated requirements in the power to vary

In retrospect many of the provisos which providers of SMSF OTDs included in powers to vary in SMSF OTDs seem unwise. Examples include provisos in powers to vary in OTDs that the trustee obtain the approval of:

  • the Commissioner of Taxation; or
  • the Insurance and Superannuation Commission;

to amendment of trust terms of the SMSF. These days the Commissioner of Taxation as the regulator of SMSFs is loathe to give such approval, which is not required by legislation, and the office of Insurance and Superannuation Commissioner no longer exists.

Unfortunately some old SMSF OTDs have these kinds of provisions and some way to deal with them needs to be worked out so that amendment compliant with the power to vary can take effect.

The right “applicable law”?

Powers to vary in SMSF OTDs frequently refer to an “applicable law”, or similar, broadly being the law that applied to SMSFs when the OTD was prepared. “Applicable law”, or whatever it may be, is usually defined in the OTD separately from the power to vary. When SMSF trust terms are generally updated, years later, the varied terms are understandably predicated on a different updated “applicable law”.

In my reckoning this means a deed varying SMSF trust terms probably needs to recognise and define two kinds of “applicable law” where compliance with “applicable law” is a proviso of the power to vary in the OTD:

  • firstly the statutes, regulations etc. that are apply to the SMSF under its updated terms; and
  • secondly the older laws prescribed as “applicable law” in the OTD, which may be redundant or repealed, which the trustee of the SMSF must nevertheless comply with to effectuate an update of trust terms in accordance with the power to vary in the OTD. The power to vary should then specifically refer to this second variety of “applicable law”. Restatement of these older laws can get complicated. For instance the Occupational Superannuation Standards Act 1987, which is often justifiably included as a component of “applicable law” in older superannuation OTDs, has been progressively renamed to the Superannuation Entities (Taxation) Act 1987,  the Superannuation (Excluded Funds) Taxation Act 1987 and the Superannuation (Self Managed Superannuation Funds) Taxation Act 1987.

An alternative view is that one stipulation of “applicable law” can suffice for the other on a reasonable interpretation of the OTD a court or tribunal may accept. That may be somewhat tenable if the OTD contains a interpretative provision contemplating amendments and re-enactments of statutes.

Still it is discomforting to rely on that interpretation of “applicable law” when the OTD specifically and restrictively defines what “applicable law” is and makes compliance with such “applicable law” a proviso to the power to vary. Adoption of multiple concepts of “applicable law” being:

  • one to support updated trust terms; and
  • the other to ground variations of the deed using the power to vary;

is a safer course in a deed to vary trust terms where “applicable law” is a proviso built into the power to vary in the OTD.

Challenges!

Proactive management of a SMSF with timely and effective amendment of SMSF trust terms to support that management can be a much more demanding and technical task then many will appreciate. It may pay for a SMSF trustee to carefully consider what the SMSF power to vary requirements in the OTD are, and what service the SMSF will be getting, rather than expecting that some plain vanilla SMSF deed amendment service is going to work.

Lost SMSF trust deed replacement deeds – are they a scam?

The writer has been reading about opportunity to replace lost trust deeds with a replacement deed from professional suppliers of replacement trust deeds, in SMSF Adviser and in other places. The writer is unconvinced that these replacement deeds are going to be legally effective particularly in relation to trust deeds to which the law in New South Wales applies.

Trust deeds lost in SA – Jowill Nominees Pty Ltd v. Cooper

On 2 July 2021 SMSF Adviser suggested that the South Australian case Jowill Nominees Pty Ltd v. Cooper [2021] SASC 76 provides an insight into issues a court will consider when a trust deed has been lost. This case concerned how trust rules of a trust governed by South Australian law can be varied by the SA Supreme Court on the application of the trustee pursuant to section 59C of the Trustee Act (SA) 1936. In the writer’s view this decision says nothing about variation of trust rules beyond the confine of a SA Supreme Court section 59C application.

Section 59C differs from the Trustee Acts to similar effect in other Australian jurisdictions including section 81 of the Trustee Act (NSW) 1925.

Regularity supports that there is a SMSF where its deed is lost

Where a trust, such as a self managed superannuation fund (SMSF), has been running for some time the trustee may be able to rely on the presumption of regularity to support the operation of the trust where the trust deed is lost.

The presumption of regularity is an evidentiary rule. It can apply where there is a gap in evidence about a prior act but where later acts and circumstances indicate likelihood that the prior act was performed. So in:

  • Sutherland v. Woods [2011] NSWSC 13 the NSW Supreme Court accepted that a SMSF trust deed and resolutions of a trustee of an active SMSF were signed on balance of probability although signed versions of these documents were missing from the evidence in the case; and
  • Re Thomson [2015] VSC 370 the Victorian Supreme Court treated a SMSF as operative in conformity with trust rules in a supposed later deed of variation even though an earlier deed of variation of the trust deed of the SMSF was lost and only an unexecuted version of the later deed of variation of the trust deed was available in evidence. Probabilities, and the surrounding facts such as the ongoing acceptance of the accounts of the SMSF based on the supposed later deed of variation, indicated likelihood that these deeds of variation had been completed and executed.

It is clear from the cases where the presumption of regularity is sought to be relied on that a court or tribunal will presume to aid a trustee unable to produce a missing deed only after an exhaustive search by the trustee for it:

He cannot presume in his own favour that things are rightly done if inquiry that he ought to make would tell him that they were wrongly done. 

Lord Simons in  Morris v. Kanssen  [1946] AC 459 at p. 475

Where a trustee of a trust, that has lost the trust deed of the trust, finds itself in dispute with the Commissioner of Taxation the presumption of regularity can counter the burden of proving the establishment of the trust on the trustee imposed by Part IVC of the Taxation Administration Act (C’th) 1953. See our post The burden of proof in a tax objection

The presumption of regularity is of procedural and not of substantive aid to establishing that a trust has been operating for some time in conformity with a valid and effective trust deed containing trust terms consistent with that operation where the trust deed cannot be produced. In the absence of evidence of the precise terms of a power of amendment, which is an exceptional power that can’t be presumed, the presumption of regularity, though, gives no substantial basis for amendment of trust terms to bring the terms of a SMSF trust deed back to terms that can be produced:

94. Variation of the terms of a trust (including by way of conferral of some new power on the trustee) is not something within the ordinary and natural province of a trustee. It is not something that it is “expedient” that a trustee should do; nor, fundamentally, is it something that is done “in the management or administration of” trust property. A trustee’s function is to take the trusts as it finds them and to administer them as they stand. The trustee is not concerned to question the terms of the trust or seek to improve them. I venture to say that, even where the trust instrument itself gives the trustee a power of variation, exercise of that power is not something that occurs “in the management or administration of” trust property. It occurs in order that the scheme of fiduciary administration of the property may somehow be reshaped.

Barrett JA in Re Dion Investments Pty. Ltd. [2014] NSWCA 367 at para 94

It follows that the presumption of regularity gives the trustee latitude to administer a trust on a presumed generic basis consistent with how that trust has been administered since inception where the trustee cannot produce the trust deed containing the trust terms. That presumption, though, would not ground alteration of trust terms where terms of a power of amendment which may not exist at all, cannot be specifically drawn on from the original trust instrument and complied with.

Law on amending lost trust deeds

How terms of a trust governed by the laws of New South Wales can be varied was considered by the Court of Appeal in Re Dion Investments Pty. Ltd. [2014] NSWCA 367. Re Dion Investments concerned an application to the Supreme Court to vary a trust deed of a trust by modernising its provisions for the benefit of the beneficiaries of the trust. In the writer’s view it is this Court of Appeal decision (by Barrett JA, whose decision Beazley P and Gleeson JA agreed with), not Jowill Nominees Pty Ltd v. Cooper, that gives insights into issues courts and tribunals, especially those in NSW, will consider when the effectiveness of instruments to amend trust terms:

  • where the trust deed of the trust has been lost and the power of amendment is not precisely known; or
  • in other circumstances where the variation to trust terms sought is not supported by, or are beyond, the power of amendment contained in the trust instrument such as in Re Dion Investments;

is to be considered.

Alteration of a trust by its founders

In the absence of a reserved power of amendment in a trust deed, can the trustee and the founders of a trust take action by a subsequent deed to vary an original trust deed (OTD)? The NSW Court of Appeal in Re Dion Investments indicates not. Barrett JA dispels this possibility where trusts and powers of the trust have been “defined” in an OTD:

41. Where an express trust is established in that way by a deed made between a settlor and the initial trustee to which the settled property is transferred, rights of the beneficiaries arise immediately the deed takes effect. The beneficiaries are not parties to the deed and, to the extent that it embodies covenants given by its parties to one another, the beneficiaries are strangers to those covenants and cannot sue at law for breach of them. The beneficiaries’ rights are equitable rights arising from the circumstance that the trustee has accepted the office of trustee and, therefore, the duties and obligations with respect to the trust property (and otherwise) that that office carries with it.

42. Any subsequent action of the settlor and the original trustee to vary the provisions of the deed made by them will not be effective to affect either the rights and interests of the beneficiaries or the duties, obligations and powers of the trustee. Those two parties have no ability to deprive the beneficiaries of those rights and interests or to vary either the terms of the trust that the trustee is bound to execute and uphold or the powers that are available to the trustee in order to do so. The terms of the trust have, in the eyes of equity, an existence that is independent of the provisions of the deed that define them.

Barrett JA in Re Dion Investments Pty. Ltd. [2014] NSWCA 367 at paras 41 to 42

Barrett JA then illustrates the point by this example:

43. Let it be assumed that on Monday the settlor and the trustee execute and deliver the trust deed (at which point the settled sum changes hands) and that on Tuesday they execute a deed revoking the original deed and stating that their rights and obligations are as if it had never existed. Unless some power of revocation of the trusts has been reserved, the subsequent action does not change the fact that the trustee holds the settled sum for the benefit of beneficiaries named in the original deed and upon the trusts stated in that deed. The covenants of a deed may be discharged or varied by another deed between the same parties (West v Blakeway (1841) 2 Man & G 751; 133 ER 940) but the equitable rights and interests of a beneficiary cannot be taken away or varied by anyone unless the terms of the trust itself (or statute) so allow.

Barrett JA in Re Dion Investments Pty. Ltd. [2014] NSWCA 367 at para 43

Alteration of a trust by all beneficiaries of a trust

SMSF Adviser and some SMSF deed suppliers express the view that persons who can compel the due administration of the trust can complete a replacement deed that varies and replaces a lost SMSF trust deed.

This view relies on a rule of equity from Saunders v. Vautier (1841) [1841] EWHC J82, 4 Beav 115, 49 ER 282. The rule is that where all of the beneficiaries of a trust are sui juris (of adult age and under no legal disability), the beneficiaries may require the trustee to transfer the trust property to them and terminate the trust. In Re Dion Investments, Barrett JA. recognises that this rule can entitle beneficiaries relying on the rule to require that the trustee hold the trust property on varied trusts:

but, if they do so require, the situation may in truth be one of resettlement upon new trusts rather than variation of the pre-existing trusts (and the trustee may not be compellable to accept and perform those new trusts: see CPT Custodian Pty Ltd v Commissioner of State Revenue [2005] HCA 53; 224 CLR 98 at [44]).

Barrett JA in Re Dion Investments Pty. Ltd. [2014] NSWCA 367 at para 46

For a trust that is a SMSF impediments to and implications of variation by the force of using the rule from Saunders v. Vautier are:

  • relatives and other dependants beyond the members of a SMSF, being all of the beneficiaries, must consent to using the rule from Saunders v. Vautier. Children, and others lacking legal capacity, who cannot consent to using the rule, are beneficiaries who can complicate use of the rule to vary a SMSF trust: Kafataris v. Deputy Commissioner of Taxation [2008] FCA 1454; and
  • if the beneficiaries do apply the rule from Saunders v. Vautier, resettlement of a SMSF trust on taking that action gives rise to:
    • CGT event E1 or E2 for each of the CGT assets of the SMSF under Part 3-1 of the Income Tax Assessment Act 1997. It follows that action taken by SMSF beneficiaries in reliance on the rule from Saunders v. Vautier will have comparable capital gains tax consequences to a transfer of all members’ benefits to a newly established SMSF; and
    • prospect that a new ABN and election to become a regulated superannuation fund for a new resettled SMSF will by required by the regulator.

Much reliance is placed by SMSF Adviser and by deed suppliers’ websites promoting replacement deed services on Re Bowmil Nominees Pty. Ltd. [2004] NSWSC 161. In Re Bowmil Nominees Pty. Ltd. . Hamilton J of the NSW Supreme Court, as a matter of expediency, allowed beneficiaries to vary a SMSF trust deed beyond limitations in the amendment power in the trust deed utilising the rule in Saunders v. Vautier on this basis:

20. Since it is appropriate that the trustee act upon the informed consent of beneficiaries who are sui juris and unnecessary applications to the Court for empowerment are not to be encouraged, I propose to adopt the course followed by Baragwanath J in the New Zealand case. I do not propose to make an order under s 81 of the TA empowering the making of the amendment, although I have expressed the view that the Court has power to do so and would be prepared to do so if it were necessary. Rather, I shall make an appropriate declaratory order to the effect that it is expedient that the proposed deed of amendment be entered into and that it will be appropriate for the trustee to act in accordance with it.

Re Bowmil Nominees Pty. Ltd. [2004] NSWSC 161 at para. 20

Update of trust terms by a court

The Court of Appeal in Re Dion Investments agreed with Young AJ, the primary judge, that post-1997 court decisions, including Re Bowmil Nominees Pty. Ltd., which relied on a misunderstanding of the extent of court power to vary trust deeds, particularly in relation to the statutory powers of a court to alter the terms of the trust viz. the aforementioned section 81 in NSW and section 59C in SA, which misunderstanding originated from this obiter dicta of Baragwanath J in Re Philips New Zealand Ltd [1997] 1 NZLR 93

The Court will not willingly construe a deed so as to stultify the ability of trustees, having proper consents, to amend a deed to bring it into line with changing conditions.

Re Philips New Zealand Ltd [1997] 1 NZLR 93 at page 99

were not correctly decided. Barrett JA said:

100. For these reasons, I share the opinion of the primary judge that the post-1997 decisions that have proceeded on the basis that variation of the terms of a trust is, of itself, a “transaction” within the contemplation of s 81(1) rest on an unsound foundation. The court is not empowered by the section to grant power to the trustee to amend the trust instrument or the terms of the trust. It may only grant specific powers related to the management and administration of the trust property, being powers that co-exist with (and, to the extent of any inconsistency, override) those conferred by the trust instrument or by law.

Barrett JA in Re Dion Investments Pty. Ltd. [2014] NSWCA 367 at para 100

In particular. the decision in Re Bowmil Nominees Pty. Ltd. and the other post-1997 decisions referred to in Re Dion Investments cannot be reconciled with the Court of Appeal decision in Re Dion Investments where Barrett JA found:

96. In such cases, however, the creation of what is, in terms, a power of the trustee to amend the trust instrument is a superfluous and meaningless step. When the court, acting under s 81(1), confers on a trustee power to undertake a particular dealing (or dealings of a particular kind), “it must be taken to have done it as though the power which is being put into operation had been inserted in the trust instrument as an overriding power”: Re Mair [1935] Ch 562 at 565 per Farwell J. The substantive power that the court gives comes into existence by virtue of the court’s order. It does not have its source in the terms of the trust. There is no addition to the content of the trust instrument. That content is supplemented and overridden “as though” some addition had been made to it. The terms of the trust are reshaped accordingly.

97. Conferral of specific new powers pursuant to s 81(1) should not be by way of purported grant of authority to amend the trust instrument so that it provides for the new powers. Rather, the court’s order should directly confer (and be the sole and direct source of) the powers which then supplement and, as necessary, override the content of the trust instrument. And, of course, the only specific powers that can be conferred in that direct way are those that fall within the s 81(1) description concerned with management and administration of trust property.

Barrett JA in Re Dion Investments Pty. Ltd. [2014] NSWCA 367 at paras 96-97

A variation relying on a power of amendment in trust terms is not a variation of a trust deed but a variation of trust terms contained in a trust deed. Barrett JA explained this in Re Dion Investments:

44. It is, of course, commonplace to speak of the variation of a trust instrument as such when referring to what is, in truth, variation of the terms upon which trust property is held under the trusts created or evidenced by the instrument. A provision of a trust instrument that lays down procedures by which it may be varied is, of its nature, concerned with variation of the terms of the trust, not variation of the content of the instrument, although the fact that it is the instrument that sets out the terms of the trust does, in an imprecise way, make it sensible to speak of amendment of the instrument when the reference is in truth to amendment of the terms of the trust.

45. Where the trust instrument contains a provision allowing variation by a particular process, the situation is one in which the settlor, in declaring the trust and defining its terms, has specified that those terms are not immutable and that the original terms will be superseded by varied terms if the specified process of variation (entailing, in concept, a power of appointment or a power of revocation or both) is undertaken. The varied terms are in that way traceable to the settlor’s intention as communicated to the original trustee.

Barrett JA in Re Dion Investments Pty. Ltd. [2014] NSWCA 367 at paras 44-45

Significance of the power of amendment as expressed in an OTD

A power of amendment of a SMSF, or any other express trust, is a precise reflection of the settlor’s (founder’s) intention of conditions for amendment of the trust communicated in the trust terms in the OTD and supplies the only lawful way trust rules in a trust deed, otherwise immutable, can be amended aside from narrow exceptions:

  • where beneficiaries can invoke the rule in Saunders v. Vautier and, by doing so, resettle the SMSF on a new trust; or
  • by court order to vary trust terms or, in NSW, to allow dealings of a particular kind despite trust terms, in accordance with a state or territory Trustee Acts such as section 59C of the Trustee Act (SA) 1936 and section 81 of the Trustee Act (NSW) 1925;

as considered above.

Amendment practice

It follows that a power of amendment in an OTD of a trust:

  • needs to remain, as it was in the OTD, as a term of the trust unless the power of amendment itself can be amended, should that be possible and has so been amended; and
  • is best extracted, repeated and given prominence in a deed of variation which replaces the other trust terms of a trust so that trust terms are clear and traceable on an ongoing basis.

Extraction and repeat of a reserved power of amendment from an OTD is not always just a matter of extracting the paragraph or paragraphs in the OTD containing the power of amendment. In the writer’s experience powers of amendment in older SMSF OTDs are frequently premised on laws and practices that prevailed when the superannuation trust was established e.g. such as in the former Occupational Superannuation Standards Act (C’th) 1987 and practices relating to now redundant regimes of employer sponsored superannuation. To remain traceable to the settlor’s (founder’s) intention as communicated to the original trustee, conditions specified for amendment in a power of amendment based on laws and practices, even where those laws and practices have evolved or become redundant since establishment of the trust; need to be complied with and reflected cogently in the extraction and repeat of the power of amendment in a deed of variation, within reason, if the power of amendment is to remain as a trust term in an exercisable form in the deed of variation.

When can a power of amendment in an OTD itself be amended?

Amendment of the power of amendment itself may be possible but unlikely if the amendment provision in the OTD itself does not expressly permit it. In Jenkins v. Ellett [2007] QSC 154, Douglas J. stated:

The scope of powers of amendment of a trust deed is discussed in an illuminating fashion in Thomas on Powers (1st ed., 1998) at pp. 585-586, paras 14-31 to 14-32 in these terms:

“In all cases, the scope of the relevant power is determined by the construction of the words in which it is couched, in accordance with the surrounding context and also of such extrinsic evidence (if any) as may be properly admissible. A power of amendment or variation in a trust instrument ought not to be construed in a narrow or unreal way. It will have been created in order to provide flexibility, whether in relation to specific matters or more generally. Such a power ought, therefore, to be construed liberally so as to permit any amendment which is not prohibited by an express direction to the contrary or by some necessary implication, provided always that any such amendment does not derogate from the fundamental purposes for which the power was created ….It does not follow, of course, that the power of amendment itself can be amended in this way. Indeed, it is probably the case that there is an implied (albeit rebuttable) presumption, in the absence of an express direction to that effect, that a power of amendment (like any other kind of power) cannot be used to extend its own scope or amend its own terms. Moreover, a power of amendment is not likely to be held to extend to varying the trust in a way which would destroy its ‘substratum’. The underlying purpose for the furtherance of which the power was initially created or conferred will obviously be paramount.”

Jenkins v. Ellett [2007] QSC 154 Douglas J. at paragraph 15

One can see the parity between what was said in Jenkins v. Ellett and in Thomas on Powers and in paragraph 94 in Re Dion Investments Pty. Ltd., as set out above, about a trustee’s proper role not being concerned to question or improve trust terms. See the writer’s article Redoing the deed https://wp.me/P6T4vg-3x#rtd

Update of the power of amendment?

The writer sees confusion among SMSF deed suppliers over the difference between the OTD and the trust terms in the OTD and who consequently fall into the trap of treating the power to amend as updatable by the same power to amend.

So instead of relocating the power of amendment in the OTD to updated trust terms, suppliers simply replace that power with their own take on an apt power of amendment departing from Barrett JA’s dictum that it is not for the trustee, far less a variation deed supplier, to “question the terms of the trust or seek to improve them”. Following Re Dion Investments and Jenkins v. Ellett a replacement of a power of amendment that is not amendable is a deviation from the power of amendment prone to be:

  • beyond the power of:
    • the parties entrusted with the power of amendment; and
    • a court, even if an order of the court for the replacement power had been sought; and
  • thus void.

Later deeds of variation of SMSFs based on a deviation

As in Re Thomson trust deeds of SMSFs will likely be varied more than once so that trust terms (governing rules) can better reflect evolving law and practice with SMSFs. An unlawful replacement of a power of amendment which deviates from the power of amendment in the OTD of a SMSF lays a trap when a trustee seeks to make a further amendment to the trust terms of the SMSF: Based on the above authorities a further deed of variation reliant on the “updated” power of amendment in an earlier deed of variation, rather than the power of variation in the even earlier OTD of the SMSF, will fail and be void unless the updated power of amendment in the earlier deed of variation is in conformity with the power of amendment in the OTD.

So are replacement SMSF trust deeds a scam?

The writer suspects many SMSF deed suppliers who supply replacement SMSF deeds don’t understand or follow the implications of Re Dion Investments. As a considered NSW Court of Appeal decision Re Dion Investments is binding legal precedent that rejects the authority of first instance NSW Supreme Court decisions referred to and discussed by the Court of Appeal, including Re Bowmil Nominees Pty. Ltd., that rest on an “unsound foundation” .

It is unfortunate that these cases are still being used as spurious authority on the websites of SMSF deed suppliers in support of claims that lost SMSF deed replacement deeds are of greater efficacy as variations of a trust deed than courts and tribunals, especially NSW courts, will be prepared to accept or order following Re Dion Investments. The writer wouldn’t say these claims are a scam necessarily because, as this post shows, the present state of law is complicated, difficult and more restrictive than understood by courts in the post-1997 cases referred to in Re Dion Investments.

The current law appears to be that if a trustee wants to vary a SMSF trust deed, which is “not something within the ordinary and natural province of a trustee” especially in NSW, the parties given power to amend under a power of amendment must locate, have and rely on that power in or derived from the OTD to successfully amend terms of a SMSF trust without resettling it.

Other solutions, aside from supreme court applications allowed under:

  • section 81 of the Trustee Act (NSW) 1925, as pursued in Re Dion Investments
  • section 59C of the Trustee Act (SA) 1936, as pursued in Jowill Nominees Pty Ltd v. Cooper; or
  • comparable legislation in other Australian states and territories;

which are expensive litigation, are unlikely to be legally effective.

It follows that every effort should be made to find trust terms in an OTD so that the power of amendment in the deed will be carefully complied with when an amendment of a trust deed is to be undertaken. That includes where there have been earlier deeds of variation of the trust terms of a SMSF whose validity also rests on, and must be derived from the reserved amendment power defined in the OTD.

ACKNOWLEDGEMENTS

The author acknowledges the articles:

  • A matter of trusts – Presumption of regularity to the rescue? Milton Louca and Phil Broderick, Taxation in Australia March 2018 at page 436
  • The powers of a Court to vary the terms of a trust A consideration of in Re Dion Investments Pty. Ltd. (2014) 87 NSWLR 753 A paper presented to the Society of Trust and Estates Practitioners – NSW Branch Wednesday 21 October 2015 by Denis Barlin of counsel (who appeared as counsel for the section 81 applicant in the case)

that were useful in preparing this post and which contain greater detail on the issues discussed. The author also expresses his gratitude that these articles have been made available openly online.

Etmekdjian – the disqualified are out of the SMSF system

You are leaving the SMSF sector

In an Administrative Appeals Tribunal decision this month in Etmekdjian v. Commissioner of Taxation  [2020] AATA 3821 (1 October 2020), the AAT refused to extend a waiver of disqualification to the applicant so the applicant could manage his own self managed superannuation fund (SMSF). The applicant had been disqualified under Part 15 of the Superannuation Industry (Supervision) Act 1993 (SIS Act).

Automatic disqualification and its waiver

There are a thin 14 days following disqualification to apply for a waiver of the disqualification once a person is disqualified: section 126B. In this case the applicant had been disqualified automatically under sub-section 120(3) of the SIS Act on conviction, by a NSW Local Court, for Commonwealth Criminal Code offences. The offences were for dishonestly backdating employee share scheme elections under former section 139E of the Income Tax Assessment Act 1936.

The applicant was outside of the 14 days allowed to seek the waiver so the applicant sought an extension of time to do so from the AAT.

AAT decision

The AAT refused:

  • to accept that the applicant’s unsuccessful appeal to the District Court against the conviction stayed the conviction by the Local Court and thus the date of automatic disqualification for section 120 purposes; and
  • to allow the extension of time as there was an absence of exceptional circumstances explaining the failure to lodge the application for waiver against disqualification within 14 days.

Context of the AAT decision and Part 15 disqualifications

Deputy President Bernard McCabe observed at the outset in paragraph 1 of the AAT decision:

Managing a superannuation fund – even a small, self-managed fund – is a big responsibility. There is a public interest in managing these funds properly given the tax advantages they enjoy. To that end, the Superannuation Industry (Supervision) Act 1993 (Cth) (SISA) establishes rules designed to ensure prudent management. Part 15 of SISA includes rules regarding disqualified persons. A disqualified person may not be a trustee, investment manager or custodian of a superannuation entity, or be a responsible officer (such as a director) of a corporation that performs those roles: s 126K. A person can be disqualified by the Commissioner of Taxation (where the Commissioner is the regulator) or the Federal Court (where the Australian Prudential Regulatory Authority is the regulator) on a variety of grounds, but a person will be automatically disqualified in circumstances set out in s 120. .…

[2020] AATA 3821 at paragraph 1

The AAT found that it only had power to extend the 14 day period strictly when exceptional circumstances warranted that extension. Deputy President McCabe concluded:

….The law requires that I identify exceptional circumstances that prevented the applicant from complying with the 14 day time limit. It is not enough to establish the applicant had a good excuse, or that non-compliance does not result in any harm, or that the applicant has a good case in relation to the substantive issue. This is not a standard ‘extension of time’ case.

21. The applicant has failed to identify any ‘exceptional circumstances’ that prevented him from making the application within the time frame contemplated in s 126B(3). In those circumstances, the decision under review must be affirmed.

[2020] AATA 3821 at paragraphs 20 and 21

The AAT’s strict approach is no surprise when it comes to the disqualification rules in Part 15. Part 15 reflects a low tolerance approach in the SIS Act to persons designated unfit to manage a superannuation fund.

Difficulties – SMSFs with a disqualified trustee/director/member

The author has seen Part 15 disqualifications happen on bankruptcy by operation of sub-section 120(1) of the SIS Act.

A person disqualified on bankruptcy, or any other disqualified person such as Mr. Etmekdjian, can’t be a trustee, a director of the trustee or a member of a SMSF. A fund with a disqualified participant falls off the register of superannuation funds as a SMSF regulated by the Commissioner of Taxation. The fund becomes (at least notionally) regulated by the Australian Prudential Regulatory Authority (APRA) instead.

So the Australian Taxation Office won’t and can’t assist once the fund is no longer a SMSF.

Unless a deactivated SMSF, on a participant becoming Part 15 disqualified, can nimbly:

  • convert to an APRA regulated fund; and
  • appoint an approved trustee;

based on a power in the trust deed of the fund to do so, or disqualified persons promptly vacate the fund to prevent deactivation, the fund reverts to an administrative no man’s land. Even arranging a roll out of benefits to another fund is fraught following deactivation. The fund won’t be practically manageable or administrable.

Time for a SMSF deed upgrade?

Lack of capability in a SMSF trust deed to convert a SMSF to an APRA fund is one of a number of indicators that SMSF trust deed may need of an upgrade to comply with today’s SIS Act requirements.

Controlling who gets death benefits from a SMSF

A widower nominated his son and daughter to take equal shares of his superannuation benefits on his death on a basis not binding on the trustee. The daughter, who was the surviving trustee of her father’s self managed superannuation fund (SMSF) after his death, appointed her husband as the new co-trustee and excluded the son from control of the SMSF. The daughter refused to pay the son the equal share of death benefits based on the father’s non-binding death benefit nomination (DBN). The son unsuccessfully challenged the daughter’s conduct in the NSW Supreme Court: Katz v. Grossman [2005] NSWSC 934.

Dilemma – the SMSF trustee’s control over where death benefits go

Katz v. Grossman reveals a dilemma with SMSFs: whoever survives a member as trustee of a SMSF generally has significant autonomy as to whom death benefits of a deceased member will be paid to by default unless the member:

  • has taken effective steps to ensure the DBN is a valid binding DBN (BDBN) to bind the trustee to pay his or her benefits to:
    • dependant/s nominated by the member; or
    • the member’s estate by nominating the member’s legal personal representative (LPR); or
  • the member has made his or her pension reversionary to their chosen dependant: although a reversionary pensioner generally cannot be an adult child as only death benefits dependants contemplated by section 302-195 of the Income Tax Assessment Act 1997 can receive pension, including reversionary pension, death benefits.

(Exceptions)

The challenge of directing death benefits to dependants

Member control of superannuation is all well and good but selection of dependants to receive death benefits, either by member’s DBN or by the trustee of the fund, is fraught and is just as prone to dispute between disgruntled family beneficiaries as disputes over wills (Wills) and deceased estates are.

With superannuation funds generally, and especially SMSFs, it is a challenge for a member to:

  • maintain an up to date expression of where he or she wants his or her benefits to go on his or her death; and
  • to effect those wishes by way of a DBN.

In many cases this will be inconsequential such as where a surviving spouse of a deceased member is the surviving trustee, or controls the trustee, and is the obvious dependant of the member to take death benefits. But where dependants are next generation, or where a member has a blended family, surviving trustee decisions to pay death benefits of the deceased may not align with the deceased member’s wishes or their DBN especially where trusteeship of the SMSF passes into unexpected and unprofessional trustee hands on their demise.

Section 17A of the Superannuation Industry (Supervision) Act 1993 (the SIS Act) limits who can be or control a trustee of a SMSF to:

  • the members of the SMSF; or
  • their enduring attorneys;

unless the fund is a single member fund and, in any case, trustees of a SMSF must be unremunerated in their role as trustee: paragraph 17A(2)(c) of the SIS Act. Member controlled superannuation by a SMSF can be a control vacuum isolated from professional trustee expertise following the death of a SMSF member unless a professional is involved in the limited ways possible under sections 17A and 17B.

Does a SMSF member need to control where their death benefits go?

Is it desirable that the member controls where he or she wants his or her benefits to go in any case? Superannuation is explicitly to provide for a member’s dependants when the member dies. The SIS Act defines a dependant:

“dependant”, in relation to a person, includes the spouse of the person, any child of the person and any person with whom the person has an interdependency relationship.

Section 10 of the SIS Act

A deceased member may nominate a dependant by a DBN that is not the dependant of the member most truly dependent or most in need of the member’s death benefits. That is why it is doubly desirable to have a competent and trustworthy person succeed the member as trustee who will genuinely assess these needs. It is on the assumption that such a trustee will survive the member as SMSF trustee that superannuation fund governing rules (SFGRs) generally give the surviving trustee an open discretion to select the dependant of the deceased member to take the member’s benefits unless one of the Exceptions applies.

So even with the guidance of a non-binding DBN (NDBN), which expresses a deceased’s wishes as to whom his or her benefits are to be paid, SFGRs, the SIS Act and trust law typically give a superannuation trustee a power to pay benefits to dependants the trustee chooses in the trustee’s discretion contrary to and despite a NDBN as occurred in Katz v. Grossman.

The binding death benefit nomination

To immunise a DBN from a wrong choice of trustee, who may select a dependant in their discretion at odds with the member’s wishes, a member can use a BDBN. A widow or widower in circumstances similar to Katz v. Grossman can prevent override of their wishes as to who is to be their superannuation dependant to take their death benefits by force of a BDBN to bind the trustee to pay to that dependant.

The BDBN obstacle course

A SMSF member seeking to impose a BDBN to control his or her superannuation needs to be sure it will take effect. There are numerous contingencies. Consider these:

  • is the capability in SFGRs allowing BDBNs effective and does it have integrity? Does the member appreciate that BDBN forms and arrangements differ from trust deed to trust deed? Not all BDBN arrangements in trust deeds are rigorous;
  • will the BDBN be validly completed? (Wareham v. Marsella discussed below is an instance of invalid completion of a BDBN);
  • if the BDBN is stated to be non-lapsing will it take effect as non-lapsing? That is: will the BDBN continue to bind the trustee more than three years after it is made? In the recent case Re SB; Ex parte AC [2020] QSC 139 a non-lapsing BDBN was accepted by the Supreme Court of Queensland. Non-lapsing BDBNs are understood to be feasible for SMSFs following:
    • Donovan v. Donovan [2009] QSC 26; and
    • Self Managed Superannuation Funds Determination SMSFD 2008/3 Self Managed Superannuation Funds: is there any restriction in the Superannuation Industry (Supervision) legislation on a self managed superannuation fund trustee accepting from a member a binding nomination of the recipients of any benefits payable in the event of the member’s death?
  • what if the member marries, divorces or commences a reversionary pension after making a BDBN?
  • will the BDBN have a fraud risk? Who needs to witness completion of a BDBN form by a member under the SFGRs? Depending on arrangements and the regime in the SFGRs for safe custody and verification of a BDBN, is there a risk that a BDBN may be altered by a dishonest successor trustee or a trustee in a conflict of interest with other dependants or “lost” so the BDBN won’t take effect as intended by the member? and
  • what if the SFGRs are subsequently amended so that a BDBN made under former SFGRs of a SMSF no longer comply with the later SFGRs?

So a member looking to rely on a BDBN to direct who will take their superannuation faces a veritable obstacle course turning on:

  • the SFGRs in the trust deed of the fund;
  • the member’s domestic circumstances; and
  • the security integrity of the BDBN arrangements;

in his or her quest to have a BDBN complied with by the trustee of the SMSF when the member is no longer around.

Better for a BDBN to be in a member’s Will?

Although a payment of death benefits is not a testamentary disposition:  McFadden v Public Trustee for Victoria [1981] 1 NSWLR 15, it is desirable that a BDBN should be set out in, or, in the least, kept with, the Will of a SMSF member to avoid some of the above contingencies.

Generally speaking Wills are:

  • subject to strict witnessing and other evidentiary requirements under state laws which reduce the prospect of fraud. By inclusion of a BDBN in a Will the BDBN can attract the same protections; and
  • revoked on marriage and, depending on state laws, altered by divorce. A dependant nominated in a BDBN may pre-decease the member. On any of these events BDBNs are ideally revisited and, in that context, a non-lapsing BDBN is especially fraught after a situation where a long-dated BDBN should have been updated to reflect changes in a member’s domestic situation. If a BDBN is in a Will there is a greater likelihood that desirable update of a BDBN will not be overlooked.

There is also the advantage of consolidated consideration and expression of the member’s wishes for his or her property and financial resources substantially in a single document. Superannuation death benefits of deceased superannuation members now frequently exceed deceased estate property governed by their Wills in value.

To include a BDBN in a Will there needs to be a basis or regime for making a BDBN in a member’s Will in the SFGRs (in the trust deed) of a SMSF. Ordinarily SFGRs/SMSF trust deeds do not provide for BDBNs to be set out in a Will and instead require the BDBN to be in a discrete BDBN form.

When there is no BDBN

When:

  1. a BDBN fails;
  2. there is a NDBN but no BDBN; or
  3. no DBN at all;

what assurance does a member have that a trustee will act in the interests of and fairly to the prospective dependants of the member?

There is initially the issue with the first and third cases that there is no satisfactory expression of what the member wishes. This situation arose in the recent Victorian Supreme Court Appeal decision in Wareham v. Marsella [2020] VSCA 92.

Wareham v. Marsella

In Wareham v. Marsella the dependants of the deceased member of a SMSF included:

  1. the deceased’s daughter from her earlier marriage, Mrs. Wareham; and
  2. her husband of 32 years up to her death, Mr Marsella.

The deceased had made a BDBN in favour of her grandchildren at the inception of the SMSF but her grandchildren were not her superannuation dependants (see the definition in section 10 of the SIS Act above) so the BDBN was invalid.

Mrs. Wareham was the deceased member’s surviving trustee. Relations between her and the husband, Mr. Marsella, were strained. Mrs. Wareham appointed her husband Mr. Wareham as co-trustee. The trustees paid all of the deceased’s SMSF death benefits to Mrs. Wareham wholly excluding Mr. Marsella.

At first instance McMillan J. held that Mr and Mrs Wareham had exercised their discretion as trustees without giving real and genuine consideration to the interests of the dependants of the SMSF and:

  • set aside the exercise of their trustees’ discretion to favour themselves; and
  • removed Mr and Mrs Wareham as trustees of the SMSF.

This result was upheld on appeal to the Court of Appeal.

The court confirmed the wide autonomy the trustees of the SMSF had to select a dependant to take death benefits:

Apart from cases where trustees disclose their reasons, the exercise of an absolute and unfettered discretion is examinable only as to good faith, real and genuine consideration and absence of ulterior purpose, and not as to the method and manner of its exercise.

from Karger v Paul [1984] VicRP 13

Mr and Mrs Wareham did not give reasons for their decision to distribute all of the death benefits to Mrs. Wareham which meant that Mr. Marsella needed to establish:

  • bad faith;
  • lack of real and genuine consideration by; and/or
  • an ulterior purpose of

the trustees in making the decision (the Challengeable Grounds).  These are all matters that are challenging to prove before a court particularly where there are no expressed reasons of the trustees for making the decision. However in this exceptional case the Supreme Court could focus on:

  • the erroneous response by the trustees’ lawyers in correspondence with Mr. Marsella over his claim to participate as a dependant. From that it could be shown that the trustees misconceived their obligation to give Mr. Marsella’s claim a real and genuine consideration. For instance, the trustees’ lawyers had asserted in the correspondence that “Mr. Marsella was not a beneficiary or dependant and had no interest in the fund”; and
  • the bad faith of the trustees. The court observed that “the decision to pay no part of the death benefit to the deceased’s husband of more than 30 years was, at least, remarkable” and the “grotesquely unreasonable” nature of the decision to exclude him was enough to establish bad faith. As there was actual conflict between Mrs. Wareham, a trustee, and Mr. Marsella the court observed that it may remove a trustee in its discretion.

Balanced against that was:

  • the trustees’ resolution to pay Mrs. Wareham which did not reveal errors that establish any of Challengeable Grounds;
  • the power of the trustees to pay death benefits to a dependant who is a trustee despite the conflict of interest; and
  • the trustees did not give evidence and so where not examined about their consideration of Mr. Marsella’s claims as a dependant;

An exceptional case

So even though Mr. Marsella was successful the case was appealed and hard fought. The trustees’ lawyer’s unlikely lapses in the correspondence and the extreme outcome and treatment of a husband of more than 30 years were vital to the result especially where SFGRs expressly permit a trustee to favour themselves in death benefits discretionary decisions despite their conflict of interest with other potential dependants that could receive those death benefits.

Where a trustee is more cautious and opaque in the course of:

  • their decision to pay death benefits to their own benefit, despite their conflict of interest; and
  • in related correspondence;

the trustee will reveal little which will give a disgruntled dependant Challengeable Grounds to challenge the trustee’s exercise of discretion.

In that respect Katz v. Grossman more likely reflects the reality facing most disgruntled family members who miss out on death benefits, especially those who are not a spouse or in an interdependency relationship. In Katz v. Grossman Mr. Katz may not have been in a position to establish the Challengeable Grounds even though:

  • his father had nominated him on a non-binding basis to take an equal share of his death benefits; and
  • his sister and her husband as trustees of the SMSF instead distributed all of the death benefits of the father to his sister.

Conclusion

It follows that the authority of Wareham v. Marsella may only assist a spouse or interdependency dependant highly deserving of death benefits as dependants in compelling cases where:

  • a SMSF’s trustee makes identifiable error in the process of discretionary decision-making to pay death benefits to himself or herself despite their conflict of interest with the deceased’s spouse or interdependency dependant; and
  • where that spouse or interdependency dependant can endure legal action to challenge the decision based on the Challengeable Grounds.

Otherwise SMSF members need to ensure the right person or people are their successor trustee of their SMSF if a Katz v. Grossman or other situation where a dependant favoured by the member misses out on death benefits is to be avoided. A valid or current expression of wishes either in a NDBN or better:

  • in a BDBN, rigorously backed by SFGRs, included in or with the Will of the member to ensure its integrity, reducing the likelihood that a payment of death benefits will be made to the exclusion of a desired or deserving family member especially where, due to the confines of the SIS Act, the member can’t be confident that their successor SMSF trustee won’t use the opportunity to favour their own benefit; or
  • where a member foresees that their dependants will be in potential conflict, in next generation or blended family circumstances, by taking steps in accordance with the SFGRs to remove trustee autonomy to make the death benefits payment decision and to instead mandate that death benefits are to be paid to the LPR of the member in compliance with core purposes of superannuation which allow payment of death benefits to the LPR under section 62 of the SIS Act. In that case the member can set out how death benefits are to be left in his or her Will.

Does a SMSF that holds only life insurance satisfy the sole purpose test?

LifeInsurance

I was recently asked if a SMSF whose only assets are an insurance policy and cash topped up by contributions used to meet premiums on the policy would comply with the sole purpose requirement in the Superannuation Industry (Supervision) Act 1993.

It depends. It will depend on the terms of the life policy and significantly on the age of the member:

The sole purpose test in sub-section 62(1) is structured as follows:

(1) Each trustee of a regulated superannuation fund must ensure that the fund is maintained solely:

(a) for one or more of the following purposes (the core purposes ):

… or

(b) for one or more of the core purposes and for one or more of the following purposes (the ancillary purposes ):

….

In other words a fund maintained for any of the listed core purposes complies with the sole purpose test. A fund maintained for an ancillary purpose or purposes also complies with the sole purpose test so long as it is also maintained for a core purpose or purposes.

The life insurance policy in question would need to be considered. Will the policy pay out insurance proceeds to the trustee of the fund on the death of the member to be used by the trustee to pay death benefits?

Pursuing a core purpose

If the policy would indemnify the trustee on the death of the member before the member:

  • ceases gainful employment; or
  • reaches age 65;

the trustee of the fund would appear to pursue core purposes either in sub-paragraph 62(1)(iv) or (iv) which are:

(iv)  the provision of benefits in respect of each member of the fund on or after the member’s death, if:

(A)  the death occurred before the member’s retirement from any business, trade, profession, vocation, calling, occupation or employment in which the member was engaged; and

(B)  the benefits are provided to the member’s legal personal representative, to any or all of the member’s dependants, or to both;

(v)  the provision of benefits in respect of each member of the fund on or after the member’s death, if:

(A)  the death occurred before the member attained the age (65) prescribed for the purposes of subparagraph (ii); and

(B)  the benefits are provided to the member’s legal personal representative, to any or all of the member’s dependants, or to both;

by taking out life cover to fund these death benefits.

Pursuing an ancillary purpose

If the life cover in the policy:

  • is in respect of the life of a member who is over age 65 and who has ceased gainful employment; or
  • only extends cover following both of those events;

then the fund is only maintained for ancillary purposes in sub-paragraph 62(2)(iii) and (iv) which are:

(iii) the provision of benefits in respect of each member of the fund on or after the member’s death, if:

(A) the death occurred after the member’s retirement from any business, trade, profession, vocation, calling, occupation or employment in which the member was engaged (whether the member’s retirement occurred before, or occurred after, the member joined the fund); and 

(B) the benefits are provided to the member’s legal personal representative, to any or all of the member’s dependants, or to both;

(iv) the provision of benefits in respect of each member of the fund on or after the member’s death, if: 

(A) the death occurred after the member attained the age prescribed for the purposes of subparagraph (a)(ii); and 

(B) the benefits are provided to the member’s legal personal representative, to any or all of the member’s dependants, or to both;

and the fund is not maintained for core purposes and so the fund does not comply with the sole purpose requirement in sub-section 62(1).

Summary

To reiterate: where the member has both:

  • reached the age of 65; and
  • ceased gainful employment;

or the policy doesn’t fund death benefits before either case then core purposes in sub-paragraph 62(1)(iv) and (iv) don’t apply to life cover taken out by the fund and the sole purpose test in section 62 could be breached for failure to pursue a core purpose in addition to an ancillary purpose or purposes.

Income from private company investments – the tax scourge of SMSFs

increase

A self managed superannuation fund (SMSF) is generally a low tax entity, particularly when in pension phase where a nil rate can apply and a low 15% rate can apply when not. Still the taxable income of a complying superannuation fund (SF) can be split into a non-arm’s length component and a low tax component under section 295-545 of the Income Tax Assessment Act (ITAA) 1997. The non-arm’s length component is taxed at the highest individual marginal rate which is 45% in the 2019-20 income year.

Non-arm’s length income

The non-arm’s length component for an income year is the complying SF’s “non-arm’s length income” (NALI) for that year less any deductions to the extent that they are attributable to that income.

NALI picked up on audit – even higher tax

The recent case in GYBW v. Commissioner of Taxation [2019] AATA 4262 (GYBW) is a cogent reminder of how NALI taxed at the highest marginal rate can arise in a SMSF. In GYBW a tax shortfall arose as the NALI not returned by the SMSF was detected in an audit by the Commissioner of Taxation. Hence even higher taxes applied including shortfall interest and penalties. There was a reduction in penalties on appeal to the AAT from “reckless” to “failure to take reasonable care” level.

NALI

Section 295-550 is one of a number of superannuation rules designed to protect the integrity of the low tax complying SF regime by combatting income shifting arrangements where income, that might be taxed elsewhere to another type of taxpayer at higher rates, is non-commercially shifted to a complying SF that attracts a low rate of tax.

Section 295-550 is directed at non-arm’s length dealings where complying SFs (and other superannuation entities) earn income from an arrangement which exceeds the income that the complying SF might have been expected to derive from the arrangement if the parties to the arrangement had been dealing with each other at arm’s length.

Where section 295-550 is enlivened all of the income from the arrangement is NALI taxed at the highest rate.

Private companies dividends prone to be NALI

At the forefront of NALI is dividend income from investment by complying SFs in private companies.

In GYBW Senior Member McCabe identified an objective test in sub-section 295-550(2) which looks at a question of fact: is a dividend paid by a private company to a complying SF consistent with an arm’s length dealing? A private company dividend paid to a SMSF is NALI to the SMSF if it is not. This objective test replaced the former provisions in Part IX of the ITAA 1936 under which private company dividends were treated as special income (the forerunner to NALI) as a matter of course. That is, unless the Commissioner exercised a discretion that it was unreasonable to treat the private company dividend as special income where the Commissioner became satisfied that the income was earned at arm’s length.

Sub-section 295-550(3) sets out factors to be considered in applying the objective test.

The facts and findings in GYBW

In GYBW, the SMSF was the SMSF of a partner in an accounting practice with the pseudonym D. His client and connection pseudonym K had volatile and valuable business interests which could earn significant income from Department of Defence contracts.

D retired from his accounting practice to become the chief financial officer of the B Group.

The various partnership and corporate dealings of K are complex and supporting evidence of them before the AAT was “difficult” and incomplete. The AAT did not accept:

  • that the evidence, though involving non-related parties D, K, K’s trust and the other partners and former partners of K; and
  • that legal advice received before the SMSF invested in B Holdings;

supported a finding that the shares in pseudonym B Holdings acquired by D’s SMSF were acquired on terms where dividends would be earned from the shares consistently with an arm’s length dealing.

Senior Member McCabe observed how parties at arm’s length from each other can engage in an non-arm’s length dealing just as non-arm’s length parties can engage in an arm’s length dealing. For instance, in the latter case, a family member of the seller acquiring stock exchange listed shares of the seller on a stock exchange. Section 295-550 is directed to the dealing viz. how the SMSF came to earn the private company dividends it earned, not to the relationship of the parties to the arrangement. The AAT was therefore sceptical about the acquisition by D’s SMSF of ordinary shares in B Holdings on its formation for a nominal sum where B Holdings was also able to obtain and exploit K’s business interests a day later which D contended had negligible value then.

That AAT observed that “Fortune shined on the business” of B Holdings and B Holdings earned more than $10 million over four years which likely explains why it was picked up for an audit by the Commissioner.

Darrelen applicable

After looking at the Explanatory Memorandum with which section 295-550 was introduced Senior Member McCabe concluded that the purpose of the section did not change nor was there any change to the factors to which regard was to be had. Therefore the Full Federal Court decision in Darrelen Pty Ltd v Federal Commissioner of Taxation (2010) 183 FCR 237, which concerned the former provisions in Part IX of the ITAA 1936, remained authoritative in Senior Member McCabe’s view. In Darrelen the court had held that dividends paid by a private company were special income. In the case the SMSF had acquired its four shares in that company for a cost far less than their market value in an earlier year of income notwithstanding that the same dividend amount was paid on all 100 shares in the income year it was paid.

The cost to the SMSF of the shares on which the dividend was paid

The cost to the SMSF of the shares on which dividends were paid is a specific factor that can be taken into account under paragraph 295-550(3)(b) in determining whether their payment is consistent with an arm’s length dealing. In applying the objective test Senior Member McCabe referred to Commissioner of Succession Duties (SA) v Executor Trustee and Agency Co of South Australia Ltd (Clifford’s Case) where the High Court set out its views on how to value shares in a company:

The main items to be taken into account in estimating the value of shares are the earning power of the company and the value of the capital assets in which the shareholder’s money is invested. But a prudent purchaser does not buy shares in a company which is a going concern with a view to winding it up, so that the more important item is the determination of the probable profit which the company may be reasonably expected to make in the future, because dividends can only be paid out of profits and a prudent purchaser would be interested mainly in the future dividends which he could reasonably expect to receive on his investment. Further, a prudent purchaser would reasonably expect to receive dividends which would be commensurate with the risk, so that the more speculative the class of business in which the company is engaged the greater the rate of dividend he would reasonably require. In order to estimate the probable future profits of a company it is necessary to examine its past history, particularly the accounts of those years which are most likely to afford a guide for this purpose. In order to estimate the rate of dividend that a prudent purchaser could reasonably require on his investment it is necessary to examine the nature of the business and the risks involved and to seek the evidence of business men, particularly members of the stock exchange and experienced accountants, who can testify to the appropriate rate from the prices paid for shares in companies carrying on a similar business listed on the stock exchange or from private sales of shares in such companies or from their general business experience.

[1947] HCA 10; (1947) 74 CLR 358 at p.362

and with the benefit of hindsight, and omissions in the evidence supporting D’s SMSF’s case about how the SMSF and B Holdings came to benefit in K’s business interests, the AAT found that dividends were not consistent with arm’s length dealing as they arose from shares acquired for less than their value so evaluated. The AAT found that the dividends received by D’s SMSF from B Holdings were NALI.

NALI rules extended to expenses

The NALI rules have extended to losses, outgoing or expenditures that are less than expected to the complying SF by the Treasury Laws Amendment (2018 Superannuation Measures No. 1) Act 2019 in Schedule 2.

Conclusion

Unless GYBW is overturned on appeal SMSF investment in a private company of a related party or in a private company of the connections of the SMSF seem destined for NALI high tax treatment. So SMSFs should be wary of investment in private companies generally: SMSF investment in a private company carries the suspicion that the investment is an opportunity to shift income from a higher taxed entity to a concessionally taxed SMSF.

It follows that the trustee of a SMSF looking to sustain concessional tax treatment needs to adequately document its dealings with and investment in private companies so the arm’s length character of the investment can be verified and, where need be, independent valuation supporting consistency with arm’s length dealing should be sought.

Changing the trustee of a trust – some elements for success

It is sometimes wrongly assumed that a minute of the current trustee is sufficient to change the trustee of:

  • a family discretionary trust (FDT); or
  • a self managed superannuation fund (SMSF) (which must be a trust with a trustee too – see sub-section 19(2) of the Superannuation Industry (Superannuation) Act (C’th) 1993 (SIS Act));

and that a change of trustee will have no serious tax consequences. The second proposition is more likely to be true, but not always.

FDTs and SMSFs invariably commence with a deed which contains the terms (the trust terms or governing rules – TTOGRs) on which the trust commences. That, in itself, is a reason why I contended in 2009 in Redoing the deed that an instrument or resolution less than a deed to change the trustee is prone to be ineffective even where change by less than or other than a deed is stated to be permitted by the TTOGRs in the trust deed.

Changing trustee relying on ability to change in the trust deed

It is thus to the trust deed that one needs to look to find:

  1. whether there is a power in the TTOGRs to appoint a new trustee or to otherwise change the trustee; and
  2. if, so, what the procedure or formalities are for doing so.

Changing trustee relying on the Trustee Acts

If ability to change trustee is not present, or is derelict, in the TTOGRs then the Trustee Acts in states (and territories) provide options for appointing a new or additional trustee which vary state to state.

Trustee Act – New South Wales

In New South Wales: section 6 of the Trustee Act (NSW) 1925 allows a person nominated for the purpose of appointing trustees in the TTOGRs, a surviving trustee or a continuing trustee to appoint a new trustee in certain specified situations such as where a trustee:

  • has died;
  • is incapable of acting as trustee; or
  • is absent for a specified period out of the state.

However an appointment of a new trustee in these situations must be effected by registered deed: sub-section 6(1) That is the deed of appointment must be registered with the general registry kept by the NSW Registrar-General, which is publicly searchable, and the applicable fee to so register the deed must be paid to NSW Land Registry Services for the appointment to take effect.

It is apparent from sub-section 6(13) that registration of a deed of appointment is not required where ability to appoint a new trustee is in the TTOGRs where the TTOGRs express a contrary intention; that is: where the TTOGRs expressly and effectively allow an appointment to be effected without a registered deed.

Trustee Act – Victoria

In Victoria there is a comparable capability for a person nominated for the purpose of appointing trustees in the TTOGRs, a surviving trustee or a continuing trustee to appoint a new trustee in writing in certain specified situations such as where a trustee:

  • has died;
  • is incapable of acting as trustee; or
  • is absent for a specified period out of the state;

under section 41 of the Trustee Act (Vic.) 1958. However this Victorian law does not impose any requirement that the required instrument of appointment in writing must be registered.

Changing trustee by obtaining a court order

The supreme courts of the states and territories are also given a residual statutory capability to appoint trustees under the respective Trustee Acts. However applying to a supreme court for an order to change a trustee of a FDT or a SMSF with sufficient supporting grounds is an option of last resort given likely significant costs and uncertainties of obtaining the order.

Changing trustee by deed

The TTOGRs in a trust deed of a FDT or a SMSF will frequently require that an appointment of a new trustee may or must be effected by a deed. It is desirable that it should do so to ensure the appointment of a new trustee does not become of a matter of uncertainty and difficulty for the reasons I have described in Redoing the deed.

Tax consequences of a change of trustee

As a change of trustee without more generally does not change beneficial entitlements under a trust, the tax consequences are usually benign:

For capital gains tax (CGT), assurance that changing trustee does not give rise to a CGT event for all of the CGT assets held in a trust is diffuse under the Income Tax Assessment Act (C’th) (ITAA) 1997:

Sub-section 104-10(2) concerning CGT event A1 states:

(2) You dispose of a * CGT asset if a change of ownership occurs from you to another entity, whether because of some act or event or by operation of law. However, a change of ownership does not occur if you stop being the legal owner of the asset but continue to be its beneficial owner.

Note: A change in the trustee of a trust does not constitute a change in the entity that is the trustee of the trust (see subsection 960-100(2)). This means that CGT event A1 will not happen merely because of a change in the trustee.

Sub-section 960-100(2) with the Notes below it in fact say:

(2) The trustee of a trust, of a superannuation fund or of an approved deposit fund is taken to be an entity consisting of the person who is the trustee, or the persons who are the trustees, at any given time.

Note 1: This is because a right or obligation cannot be conferred or imposed on an entity that is not a legal person.

Note 2: The entity that is the trustee of a trust or fund does not change merely because of a change in the person who is the trustee of the trust or fund, or persons who are the trustees of the trust or fund.

Similarly sections 104-55 and 104-60 of the ITAA 1997 which concern:

• Creating a trust over a CGT asset: CGT event E1

• Transferring a CGT asset to a trust: CGT event E2

each restate the above Note: viz.

Note: A change in the trustee of a trust does not constitute a change in the entity that is the trustee of the trust (see subsection 960-100(2)). This means that CGT event E… will not happen merely because of a change in the trustee.

Stamp duty

A change of trustee can have stamp duty consequences where the trust holds dutiable property such as real estate.

Duty – NSW

Concessional stamp duty on the transfer of the dutiable property of the trust to the new trustee can be denied in NSW to a FDT unless the trust deed of the trust limits who can be a beneficiary, for anti-avoidance reasons: see sub-section 54(3) of the Duties Act (NSW) 1997.

Indeed Revenue NSW withholds the requisite satisfaction in sub-section 54(3) unless the TTOGRs provide or have been varied in such a way so that an appointed new trustee or a continuing trustee irrevocably cannot participate as a beneficiary of the trust. Contentiously satisfaction is withheld by Revenue NSW unless a variation to a FDT to so limit the beneficiaries is “irrevocable“ : see paragraph 6 of Revenue Ruling DUT 037, even though that variation may not be plausible or permissible under the TTOGRs of the FDT.

This hard line is taken by Revenue NSW to defeat schemes where someone, who might otherwise be a purchaser of dutiable property who would pay full duty on purchase of the property from the trust, becomes both a trustee and beneficiary able to control and beneficially own the property who is thus able to contrive liability only for concessional duty and avoid full duty,

Duty – Victoria

Although the Duties Act (Vic.) 2000 contains anti-avoidance provisions addressed at this kind of anti-avoidance arrangement, there is no comparable hard line to that in NSW in sub-section 33(3) of the Duties Act (Vic.) 2000 so that the transfer of dutiable property, including real estate, on changing trustee is more readily exempt from stamp duty.

Other requirements

A prominent requirement on changing trustee of a SMSF is notification to the Australian Taxation Office, as the regulator of SMSFs, within twenty-eight days of the change: see Changes to your SMSF at the ATO website.

Where changing trustee involves a corporate trustee then there may also be an obligation to inform the Australian Securities and Investments Commission of changes to details of directors of the corporate trustee, if any. There may be further matters to be addressed if any new or continuing directors are or will become non-residents of Australia and, with SMSFs, the general requirement in section 17A of the SIS Act that the parity between members of the fund on the one hand and trustees, or directors of the corporate trustee on the other, needs to borne in mind and, if need be, addressed.

Taking out tax when superannuation death benefits are paid to deceased estates and testamentary trusts

Confusion-Blue

Who pays tax and how much when a superannuation fund pays out death benefits to a deceased estate or to a testamentary trust is not intuitive. The two technical concepts of “dependant” and “taxable component” in particular are a source of confusion.

Dependant

There are two relevant kinds of dependant. The SIS Act kind of dependant (a spouse of the person, any child of the person and any person with whom the person has an interdependency relationship – section 10 of the Superannuation Industry (Supervision) Act 1993) notably differs from a death benefits dependant under section 302-195 of the Income Tax Assessment 1997 , a subset of (SIS Act) dependant, as a death benefits dependant excludes adult children who are not disabled or in an interdependency relationship. Such an independent adult child can be a (SIS Act) dependant in receipt of a death benefit from a superannuation fund but is not a (section 302-195 of the ITAA 1997) death benefits dependant.

Taxable component

For tax purposes a death benefit is split into a taxable component and a tax fee component. The tax free component is tax free to any dependant but the taxable component is a misnomer when paid to a death benefits dependant (DBD): it’s tax free too! So of the four permutations (tax free to DBD, tax free to Non-DBD, taxable to DBD, taxable to Non-DBD) it is when a death benefits dependant receives a death benefit comprising taxable component that the benefit becomes taxable.

Re-contribution

Superannuation benefits can be paid prior to death if a member has satisfied a condition of release such as reaching the age of 65 years. This can be a way of reducing the taxable component of a death benefit that might be taxable to a dependant when paid after the member’s death. Member benefits, viz. benefits withdrawn by a member during his or her lifetime, are generally not taxable to the member where the member has reached aged 60.  It is permissible to re-contribute withdrawn benefits as non-concessional contributions back into superannuation, which become tax free component, when later paid out by the superannuation fund as death benefits.

Non-concessional limits and caps on re-contribution

However the member must be within non-concessional contribution limits to re-contribute back into superannuation in this way. At over age 65 that involves meeting the work test and being within the non-concessional caps. That is being under:

  • annual non-concessional contributions of $100,000 p.a. (no bring forward allowed for over age 65s); and
  • a total superannuation balance of $1.6m.
A look at how a taxable death benefit is taxed

A payment of death benefit that flows to a beneficiary of a deceased estate is something of a three stage event. The tax system looks through to the ultimate dependant in receipt of the death benefit (the third stage) even though the trustee of the superannuation fund may simply be paying death benefits to the legal personal representative of the deceased member who is an allowable (SIS Act) dependant (the first stage).

Non-death benefits dependants only get lump sum death benefits

Only lump sum death benefits can be paid to a dependant who is not a death benefits dependant, such as an independent adult child, so ordinarily we are looking at tax at 15% on a “taxed element” (the usual source [element] of benefits from a SMSF) but other rates can apply: see this table of rates at the ATO website https://www.ato.gov.au/rates/key-superannuation-rates-and-thresholds/?page=12

A curiosity is that taxable lump sum death benefits received by the trustee of a deceased estate are not subject to the medicare levy. Taxable lump sum death benefits viz. taxable component received directly by a non-death benefits dependant from the trustee of a superannuation fund, that is, not indirectly from the fund via a legal personal representative deceased estate dependant, is subject to medicare levy and PAYG withholding.

No PAYG withholding on lump sum death benefit paid by the trustee of the superannuation fund

The ATO also confirms that a lump sum death benefit is not subject to PAYG withholding where it is paid to:

  • a death benefit dependant (tax free); or
  • the trustee of a deceased estate – this amount is taxed within the deceased estate broadly in the same way it would be taxed if it was paid directly to the beneficiary.

https://www.ato.gov.au/super/apra-regulated-funds/paying-benefits/taxation-of-super-benefits/?default

The trustee of the superannuation fund is obliged to provide a PAYG payment summary – superannuation lump sum form (NAT 70947) to the trustee of the deceased estate within fourteen days of the payment though.

Obligations of the trustee of the deceased estate

According to the 2018 trust tax return instructions at the ATO website https://www.ato.gov.au/forms/trust-tax-return-instructions-2018/?page=43

A superannuation death benefit paid to a trustee is taxed in the hands of the trustee in the same way that it would be taxed if paid directly to a beneficiary, that is, the portions of the payment are subject to tax to the extent the beneficiary is a dependant or a non-dependant of the deceased. There is no tax payable to the extent that the payment is made to dependants or eligible non-dependants of the deceased.

At stage two, the trustee returns the taxable portions applicable to the non death benefits dependants in the trust return so that the ATO can assess the tax payable by the trustee as if the estate beneficiary/non-death benefits dependant was being directly taxed (with the taxed element generally capped to 15%).

This tax is a final tax paid at the trustee of the deceased estate level so no tax at stage three! A trustee of deceased estate should not include taxable elements of a superannuation death benefit lump sum, otherwise returned and directly and finally taxed, in income in its tax return. Then these amounts will not be further taxed at stage three as income say of a resident adult beneficiary.

Bringing trusts to a timely ending

MovingOnEnding a trust is straight forward, isn’t it? Vest all interests in the trust in beneficiaries and make the right accounting entries and the trust is terminated? Not quite.

That word “vest”. What does it mean? Vest is a technical legal term. Broadly it means to imbue with ownership of property. So, when a trust ends and the property of the trust vests, the beneficiaries of the trust succeed the trustee of the trust as entitled to the property in the trust.

But not all trusts end that way. For instance a unit trust or an unpaid present entitlement may already be vested in a beneficiary or beneficiaries. Clearly something other than vesting is needed to bring trusts of that type to an end. In those cases property that has already vested in beneficiaries may need to be paid to or put in the possession of the beneficiaries too for the trust to end.

Ending is all in the timing

In most states and territories of Australia trusts must vest within a statutory perpetuity period, typically 80 years. From this point this post relates to jurisdictions where a statutory perpetuity period applies.

Trusts that are fully vested, such as bare trusts, fixed trusts, some sorts of unit trusts and “indefinitely continuing” superannuation funds may continue for longer than the perpetuity period. A discretionary trust must vest no later than the perpetuity period, that is, discretions to distribute all income and capital of the trust must be taken and sunset once the time for vesting has been reached otherwise it will be too late and the formula for distribution for “takers-in-default” set out in the trust deed will apply to the property then left in the trust. The divesting of those interests, which are then held by the trustee outright for those beneficiaries, by payment over to, or at the direction of, the beneficiaries, can happen later after the expiry of the perpetuity period.

Bringing forward the ending of a trust

The trust deed should also set out how the time for vesting can be brought forward from the expiry of the perpetuity period. That time of expiry will usually be the “default” time for vesting, or a time just before it, (the last vesting time) in a well-crafted discretionary trust deed.

An objective of winding up a trust is to satisfy all parties with interests, in the wider sense,  in the trust, including creditors, trustees, beneficiaries and the Commissioner of Taxation.

Failure to address these interests of the parties interested, or the trust deed requirements and formalities for the bring forward of the time of vesting, can mean that the trust, or its aftermath, will remain a matter in contention or dispute which is diametrically not what a trustee will want to occur following their effort to bring the trust to an end. A trustee can face difficulty in the converse case too where a trust is inadvertently brought to an end prematurely. In other words trustees can face problems where a trust has a mistimed ending either way. A trust may go on longer than planned or it may be inadvertently brought to an end before the trust should end. An example of the latter is to be found in trust deeds which set an inexplicably early time for vesting many years prior to the expiry of the perpetuity period.

Ending by depletion and merger

Depletion and merger are two other ways a trust may be brought to an end even where the intent of the trustee and beneficiaries is, and the trust deed may suggest that, the trust is to go on for longer.

Depletion is where the trustee no longer holds property on trust. If trust property is depleted and the trustee acquires more property on trust, the arrangement is treated as a new and separate trust. A “resettlement” occurs as well as likely confusion about which trust is which. Hence the device of a “settled sum” for a discretionary trust, which remains as trust property, to ensure continuity of the (original) trust even where the trust is in deficiency and has no other identifiable property.

Merger also brings a trust to an end in an untimely and premature way. Merger occurs where the trustee and the beneficiary are or become the same person. In the case of a merger the trust obligation of the trustee under the terms of the trust is no longer owed to the beneficiary so the trust does not continue.

Merger and SMSFs with individual trustees

Merger can be an interesting issue in the case of a self managed superannuation fund with individual trustees. There is no merger while the fund has two trustees: Trustee A has trust obligations to member B and trustee B has trust obligations to member A. However if a trustee/member dies and the surviving sole trustee is also the sole member of the fund with a fully vested beneficiary account of the entirety of the fund, the fund likely merges. It follows that the fund is no longer a trust. The Commissioner of Taxation has not addressed how the doctrine of merger may apply in these cases, and, as I understand it, the Commissioner treats a fund in this situation as continuing on as a matter of administrative convenience. If the Commissioner’s approach, which may be tantamount to a recognition of a self managed superannuation fund that is not a trust, came before the courts, it is unclear how it might be explained or permitted.

Some starting points

Trusts that require winding up usually commence by and are governed by a trust deed. I am not writing here of testamentary trusts. A trust deed will usually state the requirements to wind up the trust including how the time of vesting must be brought forward. A trust deed may also provide for other things which complicate vesting or winding up, or both. The trust deed may require that a party’s consent is required before either can happen. There may be other forerunner steps which haven’t been taken which must be taken before the trust can vest under the deed. A grasp of the design or method of the trust provisions in the trust deed will build confidence that all requirements for a winding up raised in a trust deed have been identified and addressed.

If the accounts of the trust have been correctly prepared then the current balance sheet, in particular, gives a list of activity to be addressed before the trust can be wound up. For a company liquidation, liabilities need to be satisfied with the balance of assets (property) distributed to owners. Trusts are no different. The more assets have been converted to cash and liabilities have been met the simpler the contemporary balance sheet and the winding up will be.

Tax planning

The conversion of assets to cash can give rise to taxable capital gains and assessable balancing charges but the alternative, their distribution to beneficiaries on a winding up inevitably does so too. It is generally simpler or more tax effective, or both, if these CGT events are contemporaneous with the trust coming to an end.  In the cases of a fixed trust or a unit trust CGT event E4 can occur where a non-assessable part of a capital gain is distributed to a beneficiary when the interest of the beneficiary in the capital of the trust persists.

Errors frustrate the ending

Correct accounting in the trust will follow correct treatment of interests, assets or liabilities in the trust by the trustee. But correct treatment of interests, assets or liabilities doesn’t always happen. Notable examples where correct treatment doesn’t happen include:

  • the elimination of entitlements of family beneficiaries in the course of a winding up. Trustees of discretionary trusts distribute trust income to family members on lower tax rates (A) which remains unpaid and which is treated in the accounts of the trust as an unpaid present entitlement under terms in the trust deed. On winding up the distribution may revert to or may be paid to the principals of the family (B) instead without explanation. That suggests that the present entitlement of beneficiaries to former income of the trust was a sham or misunderstood with potential tax liability for the trustee;
  • distribution in the course of a winding up to individuals where the trust holds money or property sourced from a private company to which Division 7A of the Income Tax Assessment Act 1936 applies. This may be inconsistent with repayment of the money or property to the relevant company and could trigger a “deemed dividend” tax liability; and
  • backdating and forgiveness of loans – it can be tempting for a trustee to purge debts to related parties in the accounts of a trust but the purge is unlikely to be legally effective. A more nuanced treatment, which actually addresses the nature of the original transaction, is more likely to be accepted.

The Commissioner of Taxation investigates, audits and challenges trusts and the parties involved in these kinds of errors including after a winding up.

Conclusion

The affairs of trusts vary greatly and some have deeply intransigent issues. Getting a trust ready to wind up, and executing that wind up at a custom desired point in time may pose a number of challenges which should be considered and addressed in the process. The legal, accounting, business and practical attributes of the trust and possible errors should be considered through the due diligence process so that a non-contentious consignment of the trust to history can be effectively documented.

Minority SMSF investors and related unit trusts

AssociatesA popular pro-active SMSF strategy is to skirt the boundaries of the associate rules in Part 8 of the Superannuation Industry (Supervision) Act 1993 (SISA) with minority SMSF investors taking units in a unit trust with no apparent majority controller with other unrelated SMSF or non-SMSF investors. The object of the minority strategy is that the minority SMSF investor and associates have a less than 50% entitlement to income and capital of the unit trust and so the unit trust will not be a related trust of the SMSF automatically. This is an alternative strategy to investing in a non-geared unit trust which complies with Regulation 13.22C of the Superannuation Industry (Supervision) Regulations.

If the minority strategy doesn’t work

If the unit trust is, or becomes, a related trust of the SMSF the consequences can be severe. The investment in the related trust by the SMSF is taken to be an in-house asset. A SMSF that fails to remedy an investment of more than 5% of its assets in in-house assets faces loss of complying status potentially causing:

  • tax at 47% on its current income; and
  • loss of almost half of the assets of the SMSF in a one-off additional tax bill in the year in which the SMSF becomes non-complying; or
  • prosecution for civil or criminal breach of a civil penalty provision under the SISA.

An investment in a non-geared unit trust which complies with Regulation 13.22C is specifically excluded from being an in-house asset. The minority strategy does not give the same assurance to a SMSF investor in units in a unit trust which is not Regulation 13.22C compliant.

Control of a trust

The more  than 50% entitlement to income and capital test is one of the tests of control of a trust in sub-section 70E(2) of the SISA which determine whether or not a trust is controlled and is thus an associate and, by that, a related trust. An alternate test in paragraph 70E(2)(b), sometimes overlooked by users of the minority strategy, is the directions, instructions or wishes test which is an alternative test of control of a trust. Its formulation:

an entity controls a trust if:
…               (b)  the trustee of the trust, or a majority of the trustees of the trust, is accustomed or under an obligation (whether formal or informal), or might reasonably be expected, to act in accordance with the directions, instructions or wishes of a group in relation to the entity (whether those directions, instructions or wishes are, or might reasonably be expected to be, communicated directly or through interposed companies, partnerships or trusts);

is based on a similar formulation in sub-section 318(6) of the Income Tax Assessment Act 1936 which deals with associates under the income tax controlled foreign corporations (CFC) rules.

MWYS v. Commissioner of Taxation

The directions, instructions or wishes test in paragraph 318(6)(b) in the CFC rules was recently considered by the Administrative Appeals Tribunal in MWYS v. Commissioner of Taxation [2017] AATA 3037 (22 December 2017) and the companies in dispute with the Commissioner in that case were found not to be associated even though the companies concerned had the same directors.

Deputy President Logan found that, despite the unanimity of the directors of the companies involved, the companies were not associates as it could not be concluded, on the evidence, that the directors of one company, acting in that capacity, would influence themselves acting in their capacity as directors of the other company. Deputy President Logan observed that the arrangements between the companies involved: an Australian listed company and a UK publicly listed company which enabled them to dual list on the ASX and the London Stock Exchange, were for the purpose of compliance with dual listing requirements but, within that framework, the companies were structured with similarity to unrelated joint venturers. No inference could be drawn about one company acting on the directions of the other.

Moreover the strict governance which applied to both of the listed companies actually helped the companies to establish that the directors were acting independently and at arms length from the other company even where the directors were directors of the other company too. Short of a sham, or a cipher, as arose in Bywater Investments Ltd v Federal Commissioner of Taxation [2016] HCA 45 (see our blog -Why setting up offshore companies for Australians is a tricky business), the AAT was prepared to rely on the meticulous corporate documents which set out the distinct responsibilities of the directors of the companies they separately served.

Directors in common

It is certainly clear from MWYS that commonality of directors of a company, or in the case of paragraph 70E(2)(b) of the SISA, commonality of directors of a corporate trustee is not enough, in itself, to amount to a reasonable expectation that one company will act in accordance with the directions, instructions or wishes of the other company or of a group including it.

Is MWYS good news for SMSFs using the minority strategy?

Is the decision in MWYS a relief to minority SMSF investors in unit trusts concerned about paragraph 70E(2)(b) of the SISA? Maybe not. Documents of SMSF trustees and of unit trusts, in which they invest, are far less likely to be as meticulous at keeping the affairs of entities being examined for control apart. A unit trust deed is more likely than, say, a joint venture arrangement to show that the trustee of a unit trust might act in accordance with the directions, instructions or wishes of a unitholder, albeit a minority unitholder.

Frequently, under unit trust deeds, minority unitholders have the right to vote on resolutions which bind the trustee of the unit trust to act. A minority unitholder may not have the votes, alone, to so bind the trustee; but the question posed by the test is whether the trustee is accustomed to act, or whether there is a reasonable expectation that the trustee of the unit trust will act, in accordance with the directions, instructions or wishes of a minority unitholder. The answer in fact is equivocal – yes, if the minority unitholder votes are in the majority and no, if not. So yes, a part of the time or on some occasions. So the minority SMSF investor and the trustee of the unit trust are associated?

What will facts show under scrutiny?

The concern for SMSF users of the minority strategy is: will their position, that the unit trust they invest in is not a related trust, become less defensible under scrutiny from the Commissioner? From the activities of the SMSF investor, its associates and the trustee of the unit trust the Commissioner can gauge how the trustee of the unit trust has reached decisions, which may not have been in accord with documents, whether sound or not, and form a view as to how likely the trustee of the unit trust is likely to have acted on directions, instructions or wishes of the SMSF investor and its associates.

Until the circumstances of a SMSF using a minority strategy, including the relevant documents, are considered it can be uncertain whether a SMSF minority unitholder may “control” a unit trust and cause it to be a related trust.