Big and costly issues can arise with minimum pension payment failures
Failing to pay the required annual minimum payments for a pension can potentially result in severe consequences.
When an SMSF member is in pension phase they have numerous advantages such as the fund obtaining an income tax exemption for exempt current pension income (ECPI) where no tax is payable on income and capital gains to the extent the fund’s assets are funding a pension in retirement phase. However, the relevant rules in the Superannuation Industry (Supervision) Regulations 1994 (Cth) (SISR) regulating the pension must be complied with on an ongoing basis for the life of the pension.
This article examines the potentially significant and costly issues that can arise for failing to pay the required minimum payments for a pension before 30 June. For simplicity, this article focuses on account-based pensions (ABPs) and does not cover other pensions such as transition to retirement income streams, market linked pensions, allocated pensions or lifetime or similar ‘legacy’ pensions.
Why does the minimum have to be paid prior to each 30 June?
Regulation 9A(a) of the SISR requires that the rules governing the pension ensure payments of the pension are made at least annually and also ensure that the total of payments in any year (excluding payments by way of commutation but including payments under a payment split) is at least the amount calculated under clause 1 of Schedule 7. Put simply, this requires at least the minimum annual payment to be made each financial year prior to 11:59 pm of each 30 June. Given the time that electronic transfers of money takes these days, we should encourage clients to pay no later than mid-June.
What happens if you fail to pay the minimum?
In Taxation Ruling TR 2013/5 the ATO state (–):
- If a purported [ABP] fails to meet these requirements in a financial year, the [ABP] will be taken to have ceased at the start of that income year for income tax purposes. Therefore, from the start of that income year the superannuation interest is no longer supporting a [ABP] and the payments made from that superannuation interest are not [ABP] benefits. Therefore, any payments made during that income year are superannuation lump sums.
- If in the following year the relevant rules are again complied with this in effect results in the commencement of a new [ABP] and the proportioning rule must be applied to that new [ABP] when it commences.
Put simply, the pension ceases with effect from the start of the relevant financial year (ie, 1 July) in which the minimum was not paid for ECPI purposes.
Does the ATO provide any exceptions to a pension stopping?
Due to the potentially significant and costly issues that can arise for failing to pay the minimum pension, the ATO provided some administrative concessions in 2013 based on its general power of administration (GPA). This guidance was designed to mitigate the harsh outcomes that would otherwise apply in certain cases, eg, in relation to a strict application of the law where trustees made even small errors or where an underpayment was outside the trustee’s control.
Small underpayments for first time offenders can self-assess
If the minimum is underpaid by less than one-twelfth of the annual minimum amount as calculated under schedule 7 of the SISR (around an 8% leeway) and, provided the SMSF trustee is a first-time offender, the trustee can self-assess in accordance with the ATO criteria in QC 39769. The key criteria include:
- it is due to an honest mistake or its outside of the SMSF Trustee’s control;
- a catch up payment made asap (generally within 28 days of becoming aware) and the catch up is treated as relating to the prior financial year; and
- the SMSF otherwise satisfies all the other pension criteria (but for underpayment).
Interestingly, it appears that the ATO assumes SMSFs pay regular equal monthly pensions in respect of a financial year given this concession is based on a 1/12th underpayment. Most cases that we have been engaged to assist with have involved significantly greater underpayments.
Other underpayments –– apply for ATO discretion
If an SMSF trustee is not eligible for the above self-assessment concession, they must apply to the ATO to obtain any relief. Broadly, the ATO need to be satisfied that the trustee’s failure to pay the required minimum amount for the financial year was outside the SMSF trustee’s control and the fund has a clear compliance history. The ATO state in QC 39769:
Where the underpayment exceeds one-twelfth of the minimum pension payment the trustee will need to provide details of the circumstances that affected their ability to make the minimum pension payment. Each case will be considered separately on its own merits.
The ATO provide a number of examples of where it might or might not exercise its discretion based on particular background facts in QC 39769 including:
- Both members being involved in a car accident spending extended periods of time in hospital recovering from their injuries before the final pension payment where the catch up payment was made in August –– the ATO might exercise its discretion favourably.
- The SMSF trustee was overseas and the ATO would require further evidence of why failing to pay the minimum was outside the trustee’s control.
- Financial institution error – the ATO might approve.
Applying for ATO discretion under its GPA
Naturally, a well-written submission outlining all the relevant facts and providing appropriate supporting evidence would generally be required to obtain a favourable result from the ATO. In particular, the submission would need to outline how the underpayment occurred and any reasons why that was beyond the control of the trustee and any other special facts that may explain the underpayment.
We have assisted numerous clients over the years in this regard. Naturally, the ATO will also want to ensure the fund’s compliance and documentation is in order and the administration of the fund is appropriately managed. We regularly observe cases where pensions are poorly documented and where pension documents are lacking or there is no product disclosure statement (PDS). If there is any doubt whatsoever, we recommend that confirmation documents for the relevant pension are put in place.
What if the SMSF is unsuccessful –– severe consequences may follow?
If an application to the ATO is unsuccessful (and assuming the client does not want to escalate the matter further via an SMSF lawyer/expert to see if they can obtain a more favourable outcome), the following consequences will typically follow:
- The SMSF is not entitled to its ECPI concession for the relevant financial year and the period of the subsequent financial year until a new pension is commenced. The ATO view in TR 2013/5 is that the pension has stopped for ECPI purposes until a new pension is commenced.
- The affected member’s transfer balance account (TBA) will receive a debit reflective of the market value of the assets that supported the pension at 30 June of the financial year in which the underpayment occurred (see: item 6 of s 294-80(1) of the Income Tax Assessment Act 1997 (Cth) (ITAA 1997) and the paragraph 3.143 of the Explanatory Memorandum to Treasury Laws Amendment (Fair and Sustainable Superannuation) Bill 2016 that introduced the transfer balance cap and the TBA from 1 July 2017).
- Note also that the assumptions that apply under s 294-50 of the ITAA 1997 ensure that the original credit to the member’s TBA for the pension is not nullified by virtue of the pension’s failure.
- Any ‘purported’ pension payments during the period from when the prior pension ceased until the new pension commences, should be treated as lump sum payments.
- A new pension would need to be commenced which, among other things, may give rise to:
- If the affected member has an accumulation balance as well as the prior pension account balance, the tax-free and taxable components of these interests would merge and any favourable planning opportunities previously in place relating to the tax-free component might be undone.
- Typically, interim financial statements must be prepared at the time the new pension commences reflecting the market value of the fund’s assets and reflecting the accrued net earnings in relation to the fund up to the time the new pension commences.
- New pension commencement documents need to be implemented together with appropriate trustee resolutions, PDS and related notices to members and other interested parties.
- The financial services law implications under the Corporations Act 2001 (Cth) of commencing a new pension must also be considered, as the member may need to have a statement of advice prepared prior to the commencement of the pension.
- If the original pension commenced prior to 1 January 2015, it will likely lose its ‘grandfathered’ status for Centrelink income test purposes for the Commonwealth old age pension and for qualifying for the seniors health card.
As you will appreciate from the above, the potential downside costs and consequences from failing to meet the minimum annual payment can be substantial. Timely action should be taken if any underpayment is detected to establish what, if anything, can be done to minimise any potential downside. In particular, it should be noted that often the underpayment is not discovered until after the end of the relevant financial year when the SMSF accounts are being prepared or audited. Thus, the ECPI concession may be at risk not only for the prior financial year but also for a good part of the following (or current) financial year.
How long will the ATO take to respond?
The ATO could take some time to respond to an application for favourable exercise of discretion and this results in growing uncertainty. While we would generally expect the ATO to respond within 1 to 3 months we have been informed that one response took over 12 months. Any delay can result in further uncertainty and downside risk. Naturally, we would be pleased to advise on how to legally minimise risk.
Note that any backdating or fabrication of documents is a serious matter that can result in severe penalties.
What if the failure related to an adviser’s error?
If the underpayment relates to an adviser’s error or negligence, given that accountants and financial advisers should be reasonably competent and familiar with the tax and super rules, then the adviser may not be given the same ‘sympathy’ as a typical SMSF trustee/member.
Moreover, advisers that do not hold an Australian financial services licence (AFSL) need to be careful not to recommend a financial product such as commencing a new pension.
Advisers that have an AFSL need to consider whether a statement of advice or other steps need to be completed to comply with their AFSL and related legal and professional obligations.
Advisers may be without any professional indemnity cover if they provided unlicensed or legal advice.
The importance of paying the required annual minimum payments for a pension cannot be understated given the potentially severe consequences. Advisers assisting clients with pensions need to ensure their clients are aware of the importance of paying the annual amount prior to each 30 June and the downside if they do not. Seeking timely action if there is any underpayment and seeking expert advice where needed is also a key to minimising any downside consequences.
By William Fettes, Senior Associate and Daniel Butler, director, DBA Lawyers