The divorcee, the SMSF and the tax bill

PORTFOLIO POINT: Millions of dollars were removed from the couple’s SMSF after the divorce, leaving the wife with a crushing tax bill.

The rapid growth of self-managed super funds (SMSFs) and upcoming changes to superannuation – such as reduced concessional contribution caps, and personal tax rate changes from July 1 – mean super will continue to feature in the news.

The flexibility and control offered by SMSFs have prompted many people (often married couples) to set them up. However, having these funds in the family doesn't always work out.

Recently, the Administrative Appeals Tribunal affirmed that an SMSF was a non-complying fund for the year ended June 30, 2005 – essentially because money was withdrawn by the husband trustee before the fund members had reached their preservation age.

The fund's trustees were a husband and wife – Mr and Mrs Shail. The fund was established in January 1994 and became a regulated SMSF in November 2000. The two trustees had been married since December 1980 but divorced in 1992. There was a division of marital assets, although Mrs Shail relied on her husband to be her financial adviser. He also acted as her tax agent. The super fund continued after the divorce.

Between May 9 and June 6, 2006, about $3.4 million was removed from the fund's cash management account and transferred to an overseas bank account of Mr Shail. Mrs Shail claimed she knew nothing of this. The fund also claimed a deduction for the misappropriated funds.

At the time of the transfer, neither Mrs Shail nor her husband had reached their preservation age, and no condition of release for the payment of benefits had been met. In addition, no income tax return for the fund was lodged for the 2005 year.

The AAT said Mrs Shail argued that she was not liable to pay tax (as a trustee or otherwise) on income taken from the fund by her husband.

The tax commissioner issued a notice of non-compliance to Mrs Shail and a default income tax assessment assessing the taxable income of the fund to be $3,369,944 with associated tax payable of just over $1.5 million. In addition, the Commissioner also issued a penalty assessment of $1.4 million in relation to the shortfall.

Mrs Shail argued that since she had no knowledge of her husband's acts as co-trustee, she could not be held accountable for his actions. In addition, she said she had not derived any income as a trustee or in her own right or in any other way, as a consequence of her husband's breach.

She also argued that, in any case, the fund was entitled to a tax deduction in respect of the misappropriated amount, which would have meant that the taxable income of the fund would have been nil. Mrs Shail also claimed that the 75% administrative penalty imposed was incorrect as there had been no intentional disregard of the law.

While the tribunal acknowledged that it was not difficult to feel some sympathy for the position in which Mrs Shail found herself, it said that any appearance of unfairness to her as an individual should not obscure the nature of the fund itself, the role of trustees or the regulatory regime within which they function.

It held that the fund was nonetheless a non-complying fund for the year ending June 30, 2005, as it had failed to pass the compliance test in the superannuation legislation. The tribunal found the tax commissioner was justified in issuing an assessment.
It said that "although the taxation consequences are clearly significant to [Mrs Shail], this is insufficient in the Tribunal's opinion to overcome the seriousness of the contravention". It said if it had found that the fund was complying under the law, that finding would have undermined the objects of the legislation and the policies underpinning it.

Further, the tribunal held that no deduction was available for the misappropriated funds to reduce the taxable income of the fund as the relevant tax law requirement was not satisfied (as the funds were not misappropriated by an employee or agent).

The tribunal considered that it could not be the intention of the law that a fund would be entitled to deduct a loss for which the trustee was responsible. It also said there was no evidence that Mrs Shail knew of the loss in the financial year ending June 30, 2005, and hence no deduction would be available in any case.

In relation to penalties, the tribunal said Mrs Shail bore the onus of proving that the amount of taxable income assessed exceeded the actual taxable income of the fund, and she had failed to demonstrate that the tax commissioner's estimates were excessive. Hence, it held the 75% shortfall penalty was appropriate given the "flagrancy of the breach by the trustee of the Fund as an entity" and that there was no basis for remission.

The tribunal did note however that the tax commissioner had implicitly acknowledged in the course of proceedings that Mrs Shail may have grounds for claiming a remission of the General Interest Charge imposed with respect to her lack of knowledge of the assessment and penalty notice during the period May 15, 2006 to April 16, 2009.

The laws and rules governing self-managed super funds are detailed and can be complex to understand. Having a husband and wife as the only trustees is not necessarily a problem. However, where a marriage breaks up, there can be consequences for the super fund. The trustees are liable for the fund, and any breach of the relevant laws will have consequences for the fund, whether both trustees are aware of the breach or not.

Terry Hayes is the senior tax writer at Thomson Reuters, a leading Australian provider of tax, accounting and legal information solutions. This article first appeared in SmartCompany.