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The new penalty regime - A big stick over trustees and advisors?

On 5 Septebmer, I presented  at The Ninth Annual SMSF Conference, a two-day conference organised by Television Education Network Pty Ltd on SMSF Penalties titled, "Administrative directions and penalties for SMSF contraventions after 1 July 2014. The new penalty regime - A big stick over trustees and advisors?"

 

A copy of the paper can be accessed here

 



Introduction

With effect from 1 July 2014, the Australian Taxation Office has new weapons in its arsenal to assist it in its role in regulating Self Managed Superannuation Funds.

 

SMSF Trustees and their Advisors need to be aware of this new administrative direction and penalty regime and understand that these new provisions are additional to and not in substitution of the previous regime, which is still in place. It is still possible for the Commissioner to use its pre-existing tools to deter and address SMSF non-compliance, including amongst other powers:

  • Making a SMSF non-complying for taxation purposes;
  • Applying to court for civil or criminal penalties;
  • Enforceable undertakings; and
  • Disqualifying a trustee.

The new rules are intended to provide a lower scale of consequences for less serious breaches, including:

  • Rectification Directions
  • Education Directions
  • Administrative Penalties

The Explanatory Memorandum to the 2014 Bill which introduced the new provisions explains:

Applying current penalties can be costly and time-consuming and the potential consequences can be disproportionally high. The Regulator is unlikely to use his existing range of powers except in cases of significant non-compliance with the law.

The power to give directions and impose administrative penalties for contravention for the SIS Act will provide the Regulator with additional tools, both educational and punitive, in conjunction with his existing powers. These tools will be effective, flexible and cost-effective mechanisms for imposing sanctions that reflect the nature and seriousness of the breach, and will support the integrity of the system. (1)

 

There is no doubt that the ATO needed to have sanctions available that provided for less draconian consequences for non-compliances . (2)  It is not clear, however, where the ATO will delineate between degrees of seriousness of breach. It may be that the outcome in cases with facts similar to recent cases will not change. Clear guidance from the ATO in relation to this is desperately needed.

 

This paper will examine the new regime, as well as potential new applications of the previous regime. It will also look at what advisors should do in the event of a penalty or other notice.

 

PART 1 - The new penalty regime

What it means for trustees and their advisers

The new penalty and direction regime is contained in Part 20 of the Superannuation Industry (Supervision) Act 1993 (Cth) (ss 157 to 169) (SISA)).

 

1. Rectification Direction

s 159 of SISA

Section 159 applies where the ATO reasonably believes a trustee, or the director of a corporate trustee has contravened a provision of SISA or the Regulations.

 

By written direction, the ATO can require a person to undertake a specified action to rectify the contravention within a specified time frame and require the person to provide evidence of compliance.

The ATO must have regard to:

  • Any financial detriment which might reasonably be expected to be suffered by the Fund as a result of person’s compliance with the direction;
  • The nature and seriousness of contravention;
  • Any relevant circumstances.

Section 159(5) states that the ATO must not give a Rectification Direction for the same contravention that is the subject of an enforceable undertaking via s 262A, provided circumstances are still the same.

A person must comply by the end of specified period or commit an offence of strict liability, with a penalty of 10 penalty units (3)(section 159(7)).

 

Because the offence is one of strict liability (4), this means that the ATO does not need to establish fault or intention on the part of the trustee. This applies to both rectification and education directions (see below). This is a deliberate feature of the changes and is designed to remove most defences and discourage careless non-compliance.

 

The ATO must bring criminal proceedings to establish the offence.

 

2. Education Direction

s 160 of SISA

Section 160 applies where the ATO reasonably believes that a trustee or the director of a corporate trustee has contravened a provision of the SISA or the Regulations.

 

By written direction, the ATO can require a person to undertake a specified approved course of education (see s 161) within a specified time frame and provide evidence of completion of such course.

 

A person must comply by the end of the specified period or commit an offence of strict liability, with a penalty of 10 penalty units.

 

The specified or required education courses must be provided free of charge. The ATO has the ability to approve such courses. Any incidental costs incurred by a person complying with an education direction cannot be indemnified from or paid by the fund (travel, incidental expenses).

Education and rectification directions are likely to apply at the lower end of the scale of seriousness.

 

Variation of Directions

By written notice, a rectification direction or an education direction can be varied by the ATO at any time – s 163

Further, a person to whom a rectification or education direction is given may request the ATO to vary that direction – s 164

 

Any request must state the reasons for variation.

The ATO must decide to:-

  • vary the direction per the request;
  • vary in a manner other than requested; or
  • refuse to vary the direction at all.

If no decision is made within 28 days of request, the ATO is taken to have refused to vary.

 

Taxation Objection

If a person is dissatisfied with the ATO’s decision to give a Direction, vary a Direction other than as requested or to refuse to vary; the person may object to this Decision in manner set out in Part IVC of Taxation Administration Act 1953 (Cth).


3. Administrative Penalty

If one of the provisions set out in table at s 166(1) are contravened by a trustee or a director of a corporate trustee, that person is liable to an administrative penalty.

 

Penalties are set out in penalty units in the table at s 166(1), with a penalty unit currently equating to $170 s 4AA Crimes Act 1914 (Cth).

 

A penalty paid by a person must not be reimbursed by the Fund.

The penalties in section 166 are as follows:


 

Note that failure to comply with an education direction is both an administrative penalty and an offence of strict liability.

If proceedings are (or are subsequently) commenced against person for a contravention of a civil penalty provision via Part 21 of SISA, then that person is not liable to pay the amount of the administrative penalty. Any amount paid or applied by the ATO must be refunded or applied in total or partial discharge of other tax-related liability of person. – s 168

 

It is also possible for multiple penalties to be applied at one time, for example there may be one-off breaches or breaches that continue across more than one financial year. Administrative penalties can be applied against each contravention and are cumulative.

 

Administrative penalties will also be applied in conjunction with existing penalty regime (noting the exception for existing enforceable undertakings). How the ATO will use these new powers and penalties in conjunction with ability to seek penalties from the Courts and/or to issue notices of non-compliance is as yet untested.

 

4. Promoter Penalties

Also introduced by the amending Act is the imposition of penalties for persons who promote illegal early release schemes.

 

The penalties hone in on a person who promotes a scheme that has resulted or is likely to result in a payment being made from a fund otherwise than in accordance with the payment standards in the Regulations.

 

A new s 68B is inserted into SISA, setting out that a person will contravene the new provision if a scheme is likely to result in a payment being made from a regulated superannuation fund other than in accordance with the payment standards. The section includes definitions of ‘promote’ and ‘scheme’ and is discussed in detail in the Explanatory Memorandum.

 

In accordance with the existing civil penalty provisions in Part 21, a Court may make an order that a person contravening the promoter penalty pay a penalty of up to 2,000 penalty units, ($340,000) and imprisonment not exceeding five years.

 

5. Do the changes create liability for advisors – directly or indirectly?

In the new sections of Part 20 there are no direct links to advisor liability.

Nonetheless, appropriate advice and care will need to be taken in advising clients in relation to all existing provisions, including to:

  • Rectify any existing contraventions
  • Ensure audits and returns are up to date and lodged
  • Seek enforceable undertakings where contraventions may take longer to rectify (i.e. across a number of financial years)
  • Seek appropriate advice where necessary from auditor and/or legal professionals

As always, there are professional indemnity risks for advisers who:

  • have advised clients incorrectly;
  • have failed to reasonably appraise them of their responsibilities in relation to existing and new provisions of the SISA;
  • fail to provide appropriate or timely advice in relation to responding to new Rectification & Education Directions and Administrative Penalties; or
  • were involved in a breach of s52 SISA covenants.

Noting also it is not beyond scope that the promoter penalties that could stretch to advisers.

 

Trustee administrative breaches – what must they do to avoid penalty?

The new system is as yet untested and there is still limited information from the ATO as to how they will use these rectification and education directions and how flexible they will be with requests for variation.

The role of trustees, and their advisors, is simple: comply with the SISA and regulations.

If a contravention occurs: ensure it is rectified as soon as possible. The ATO has stated it will consider the scenario for trustees who are working towards rectifying a contravention that cannot be simply rectified.

Comply with any rectification or education direction within the time periods specified.

Where possible and necessary seek timely variation of the directions if compliance within specified time periods is not possible.

 

Ensuring no fraud in fund

There are two potential fraud related issues that may have consequences for trustees and their advisors:

  • Third party fraudulent behavior, or theft, particularly in relation to investments of the SMSF – eg, the Trio Capital collapse;
  • The trustee and/or their advisors incorrectly keeping records with the intention of deceiving or misleading the ATO or defeating the purposes of the SIS Act – see section 307 of the SIS Act.

Either case can have drastic consequences for members, trustees and their advisors. Section 307 in particular provides an offence for fraudulently deceiving the ATO, punishable on conviction by imprisonment for a term not exceeding two years.

 

Third party fraud and section 55(3)

The collapse of Trio Capital has been the subject of much political point scoring, culminating in a Department of Treasury review and assessment into shortcomings in the regulatory framework (in addition to previous reports by Richard St John and the Parliamentary Joint Committee).

 

A critical feature of the Trio Capital collapse was the stark difference in statutory compensation mechanisms between superannuation funds regulated by APRA (under Part 23 of the SIS Act), compared with SMSFs, which unlike APRA funds, are ineligible for compensation in the event of theft or fraud.

 

The Treasury Report reached the following conclusions, amongst others:

  • Certain financial planners and advisors played a critical role in the Trio case, particularly in relation to advising SMSF trustees to invest;
  • In doing so they may not have put their clients first or given adequate advice as to risk;
  • APRA and ASIC carried out their roles and responsibilities appropriately;
  • Some SMSF trustees had an insufficient understanding and knowledge of the risks pertaining to their investments; and
  • Inadequate financial advice may have been a contributing factor.

Enforcement action has been taken against individuals associated with the Trio Capital fraud, and investigation into others is continuing (as of April 2013).

 

The language used by Treasury, possibly deliberately, appears to directly reference section 52 of the SIS Act, particularly the covenants in s52(2)(b) and (f) by the trustee of a superannuation entity:

  • To exercise in all matters affecting the entity, the same degree of care, skill and diligence as an ordinary prudent person would exercise…
  • To formulate and give effect to an investment strategy that has regard to the whole of the circumstances of the entity, including but not limited to the risk involved in … the entity’s investment.

While section 52 is directed at contraventions of covenants by trustees, section 55, which deals with the consequences of contraventions of a covenant, is clearly wide enough to encompass contraventions that result from the involvement of a third party advisor. Section 55(3) provides:

  • A person who suffers loss or damage as a result of conduct of another person that was engaged in contravention of subsection (1) may recover the amount of the loss or damage by action against that person or against any person involved in the contravention. (emphasis added)

“Involved” was defined in section 17 until 2001 to include people who have aided, abetted, counseled or procured the contravention. The section was repealed only to standardize the definition with a similar definition in the Criminal Code (5). Accordingly, the meaning of “any person involved in the contravention” in section 55(3) is certainly wide enough to encompass advisors who encourage SMSF trustees to undertake dubious investments.

 

Until now, members of super funds appear to have only brought claims for compensation under section 55(3) against trustees, and only in one case has the trustee been of a SMSF (6). Nevertheless, it is likely that this provision will be used more frequently in future to claim against advisors who have caused loss or damage to a SMSF.

 

In addition, SMSF trustees have their usual rights in tort and contract to claim damages against advisors.

There is one important practical issue in relation to claims for compensation – most professional indemnity policies will exclude coverage when an allegation of fraud is raised. This exclusion may be limited to proved fraud, but policies do exist that exclude allegations of fraud, including fraud by parties other than the insured advisor.

 

In situations such as Trio Capital, where fraud was involved (albeit not the fraud of the SMSF’s advisor, or even Trio Capital itself, but of the ultimate managed investment schemes in which Trio Capital invested), there is a real risk that the advisor’s insurers will deny coverage to the advisor. Whether the insurer is correct to do so is another matter, however, it rapidly becomes too costly to sue firstly the advisor and then the advisor’s insurer in order to ultimately obtain compensation.

 

Defences to claims for compensation under section 55(3)

There are a number of defences to section 55(3) claims in the SIS Act.

Section 323 provides defences that mirror the common law: reasonable mistake, reasonable reliance on another person, actions of another person.

 

Section 55(5) relevantly provides a defence in relation to loss or damage suffered as a result of the making of an investment, if the defendant establishes that the investment was made in accordance with an investment strategy. This recognises the significant onus on trustees and advisors to ensure that the SMSF’s investment strategy is followed. Furthermore the covenant relating to investment strategies in section 52(2)(f) must be observed, including:

  • The risk of the investment
  • Diversification
  • Liquidity
  • Ability to discharge existing and prospective liabilities.

Too often investment strategies are seen a mere formality and not an essential part of SMSF advice. This is particularly so with relation to the geared SMSF property investment market, which is now maturing. If there is a downturn in this property sector, the fallout will be interesting.


Part 2 – what happens next

Variation of Rectification or Education Directions

If a trustee is dissatisfied with a rectification or education direction, and wishes to challenge it, the trustee may do so by written notice, seeking that the ATO vary the direction – s164.

 

The trustee must make apply to vary the direction before the date by which they are required to comply with the direction

Any request must state the reasons for variation.

The ATO must decide to:-

  • vary the direction per the request;
  • vary in a manner other than requested; or
  • refuse to vary the direction at all.

If no decision is made within 28 days of request, the ATO is taken to have refused to vary.

The variation request and any subsequent objection (see below) will not delay the operation of the strict liability provisions for failure to comply with either the education or rectification direction.

 

Administrative penalties

The administrative penalties for contraventions set out in section 166 operate differently from the strict liability offences for failure to comply with the education or rectification directions.

The ATO does not need to convince a court of the elements of the offence (as it would for the above offences, failure to comply with an enforceable undertaking and the civil and criminal penalty provisions). Instead, the ATO can simplify notify the trustee of the penalty and then recover the penalty in the same way as any other tax debt (7).

 

Liability of individual trustees v directors of corporate trustees

Directors of corporate trustee are jointly and severally liable for administrative penalties. – s 169. On the otherhand, individual trustees are each liable for the full penalty. In addition, individual directors and trustee can be personally liable for breaches made in their personal specific capacity (for example, a failure to sign a trustee declaration in contravention of s104A(2)).

Is it negligent therefore not to advise individual trustees to incorporate?

 

Taxation Objections and appeals

A SMSF trustee may object under Part IVC of Taxation Administration Act 1953 (Cth) to the following new provisions:

  • Administrative penalties
  • Rectification or education directions
  • Decisions of the ATO to refuse to vary rectification or education directions

The exercise of the ATO’s discretion under s42A(5) of the SISA to make a fund non-complying, continues to be a reviewable taxation decision under Part IVC, as does excess concessional contributions tax determinations.

The Part IVC objection process includes statutory requirements for the ATO to decide the objection (8) and in the event of an unfavourable decision to appeal that decision either to the Administrative Appeals Tribunal (AAT) or the Federal Court.

Prior to the new provisions, the AAT in particular has expressed in virtually every decision the primacy of the objects of the legislation over perceptions of harshness.

“While tragic, the present circumstances are not those in which a discretion ought to be exercised consistently with the principles governing exercise of discretionary powers.

To do so would frustrate the wider objects of the SIS Act by relieving those responsible for superannuation funds of tax imposts …” (9)

In doing so, the AAT has followed the judgments of the Federal Court, including the following general statement of position from Logan J:

“…in return for regulation found in the SIS Act, particular taxation benefits are given to the Trustee of a superannuation fund and its members.

It is a privilege. It is a privilege that should not be abused….” (10)

 

The new powers will give the AAT greater options to direct the ATO to substitute lesser sanctions, in situations where the AAT forms the view that the ATO has been excessively harsh.

It will be some time before the degrees of seriousness are fully explored by the ATO and the AAT. No doubt there will be future cases where reasonable minds will differ as to the whether a particular contravention is so serious as to warrant a determination that the funds should lose its complying status. It is also likely that the ATO will at some point get it wrong. The welcome aspect of these changes is that the AAT can now overrule the ATO without detracting from the broader objects of the legislation.

 

(1)  Explanatory Memorandum to Taxation and Superannuation Laws Amendment (2014 Measures No 1) Bill 2014, para 2.8 

(2)  For example Shail Superannuation Fund [2011] AATA 940 and Triway [2011] AATA 302 

(3)  A penalty unit is currently $170
(4)  Section 6.1 of the Criminal Code
(5)  EM of No 31 of 2001
(6) Dunstone v Irving [2000] VSC 488, where one trustee / member sued the other.

(7)  See Section 298 of the Taxation Administration Act 1953. 

(8)  Section 14ZY
(9)  Triway [2011] AATA 302

(10) DFCT v Fitzgeralds (2007) 2 ATC 5105
 

Posted in: Tax & ATO News Australia at 26 September 14

SPAA SMSF National Conference 2013

Day one of the conference is now done and I am well and truly into the swing of day two.  You can see the some of the highlights of day one here including  a round up of the speakers for the day.

Posted in: Tax & ATO News Australia at 14 February 13

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Author: David Hughes

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