Compliance concerns with overpaid present entitlements resurfacing

“I’m seeing a lot more of these come through on the balance sheets of unrelated and related entities,” Ms Banton said.

Where an SMSF accepts distributions from a related unit trust in excess of their entitlement, SMSF professionals need to determine whether those overpayments are considered to be a borrowing by the fund and a breach of section 67, she said.

“We have to work out whether that’s the case or not,” Ms Banton said.

The other question that needs to be considered is whether the fund is attempting to circumvent the contribution caps or attempt to transfer illegal assets into the fund, she explained.

Ms Banton noted that SMSFR 2009/3 outlines the ATO’s views on related unit trusts and the implications associated with distributions.

“Unfortunately, none of those examples specifically covered overpaid present entitlements. So we need to look at SMSFR 2009/2, which addresses the meaning of borrow money or maintain an existing borrowing of money to shed further light on whether the fund is breaching the borrowing rules or not,” she explained.

Based on that ruling, a borrowing is an arrangement that exhibits two necessary characteristics, she said.

“The first one is a temporary transfer of an amount of money from one entity, the lender, to another, the borrower and an obligation or intention on the part of the borrower to repay that amount to the lender. That can also be satisfied by transferring an asset through to repaying that borrowing,” she said.

Examples of these types of transactions can include margin lending accounts, bank overdrafts, and secured or unsecured loan once they’re drawn upon, she explained.

“Normally, we don’t see an overpayment of present entitlements involved in the redemption of capitals, and the fund records it as a credit in the financial statements because there’s no intention to repay that credit,” she said.

“The other thing to note here is that there’s no loan agreement, there’s no interest paid by the fund, and there’s no contractual agreement that the credit has to be repaid either. What we would expect to see [is] that the credit is reduced as the fund’s present entitlement to distributions actually accrues.”

Ms Banton warned that SMSF trustees also need to be careful here because where there is an arrangement that’s not a borrowing and that’s not described as a borrowing but exhibits all the necessary characteristics of a borrowing, then they will have a contravention of section 66.

“Basically, if it looks like a duck, walks like a duck and quacks like a duck, then it’s going to be a duck,” she cautioned.

“An example of this type of situation is where it started out without the intention of a loan or borrowing, but it develops into that because the trustees have made a different choice, such as they haven’t reduced the overpayments from those present entitlements that are coming through.”

Ms Banton said she has come across funds recently where there has been a related-party trust and the overpayments to the other related parties haven’t been in line with the proportion of the units they held, which meant the fund was effectively providing a loan to a related party that had cash flow issues.

“In line with regulation 13.22D wasn’t at arm’s length and therefore regulation 13.22C no longer applied, and it busted the trust,” she warned.

“What we want to see when these overpayments occur every year when, we’re assuming more see them every year, is that they’re firstly distributed proportionately in relation to the unit holders holding, and then they’re netted off in the next year. So under those circumstances, and assuming there are no other things that we need to be aware of, it shouldn’t be a problem.”

One of the biggest issues, Ms Banton said, is where it occurs on a one-off basis, and then the trustees try to pay it back.

“This indicates that there are other circumstances that we need to be aware of because that’s going to be the kiss of death for a related-party trust because you have a loan,” she said.

On face value and where there are no other extenuating circumstances, Ms Banton said an overpayment of present entitlement isn’t considered to be a borrowing.

“However, like anything else, if it keeps on happening and it comes through with a lot more regularity, and it gets on the ATO’s radar, we may see some changes in this space to the current ruling, and that could adversely super impact super funds,” she warned.

“That could mean there may be problems accepting these types of overpaid present entitlements in the future.”