There are many ways in which the Australian Tax Office (ATO) can punish self-managed super funds and their trustees who break the law. Knowing how to avoid the most common legal problems will make managing your super fund much smoother.

If your SMSF is found to have breached a law, the ATO could make it ‘non-complying’ – a penalty that has quite disastrous results. In the financial year a fund’s complying status is removed, it effectively loses half its assets (less non-concession contributions) in tax penalties.

The ATO could also disqualify, suspend or remove the trustees, freeze the super fund’s assets, accept an undertaking (or legal promise) from the trustees to fix up a contravention of a law, and seek civil or criminal penalties through the courts against those involved in the breach. And of course, it might also apply various tax penalties.

Knowing how to avoid these penalties is clearly quite important.

The ATO must establish two criteria before it can inflict these substantial penalties: the seriousness of the breach and all other relevant matters. But what do these terms mean?

The seriousness of the breach

The ATO must determine ‘the seriousness of the breach’ by looking at the behaviour of the trustees (was the mistake deliberate or an honest mistake?), how the breach impacted the fund’s assets, if the trustees’ actions have exposed the fund’s assets to unreasonable risk, the number and duration of the breaches, and the nature of the breach in the overall scheme of the super laws.

Other relevant matters

The ATO is required to determine any ‘other relevant matters’, such as whether the trustees have fixed-up the breach, the skill and knowledge of the trustees, the compliance history of the fund before the breach occurred, and the events that led to the contravention.

If the tax office makes a super fund non-complying, the trustees can object to either the ATO, the Administrative Appeals Tribunal (AAT) or to the Federal Court (there are different objection processes available depending on how you prefer to proceed with your complaint). Typically, most people object to the ATO first and if they get knocked back, they tend to take it to the AAT for another review.

If you’ve run into problems and plan to approach the AAT, prepare yourself well because the AAT has recently been taking a harder-line approach to non-complying cases than it has in the past.

Key mistakes

So, what are some of the key mistakes SMSF trustees make?

1. Using fund money for personal or business reasons – for example, paying personal bills or loaning super fund money to your relatives or your business.
2. Using fund assets for personal purposes prior to retirement – this is often a breach of a test called the Sole Purpose Test, which tests to make sure that the SMSF exists for the ‘sole purpose’ of providing for your retirement.
3. Withdrawing money from the super fund illegally.
4. Placing business assets in super and then using those assets without a formal lease in the running of your business – often the mistake here is that no lease payments are being made.
5. Not completing statutory and income tax reporting requirements – a surprisingly large number of SMSFs do not complete their statutory reporting requirements to the ATO and many also fail to pay their annual levy.
6. Making the fund a non-resident super fund – such funds may not be non-complying but they face similar tax penalties. It’s important to look into this rule if you plan to move overseas temporarily or permanently.

As mentioned above, there are other penalties that could be applied. In a recent AAT case, the owners of a small business got into financial difficulty and borrowed money from their SMSF on behalf of the business. In time, the business’s trading performance recovered and they repaid the loan. Although the breach of the super laws had been rectified, the ATO elected to tax the money withdrawn from the super fund as an illegal withdrawal of fund assets.

The super laws allow the ATO to tax such withdrawals at a taxpayer’s marginal tax rate rather than at the SMSF’s preferential rate. The ATO applied this section of the law in this particular case. The taxpayers complained to the AAT, but the tribunal rejected their application and found that the ATO penalty was appropriate because they had not operated their super fund appropriately.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.