Is an overpaid present entitlement a borrowing?
Determining whether an overpaid present entitlement is a borrowing will depend on a number of important conditions.
When an SMSF receives an overpaid present entitlement, the first question is whether it represents a borrowing.
There is a lot at stake because the penalty for a breach of s67 SIS is 60 penalty units or $16,500 per trustee from 1 January 2023 (effectively ending the debate over individual versus corporate trustees).
Other questions also arise, such as whether the SMSF is attempting to circumvent the contributions caps or transferring illegal assets into the Fund.
The ATO released SMSFR 2009/3, outlining how SIS applies to unpaid trust distributions for SMSFs. Unfortunately, it does not cover overpaid present entitlements.
However, SMSFR 2009/2 addresses the meaning of “borrow money” or “maintain an existing borrowing of money”, which sheds further light on whether the Fund breaches the borrowing rules.
What is a Borrowing?
According to the ruling, a borrowing is an arrangement that exhibits two necessary characteristics:
- a temporary transfer of an amount of money from one entity (the lender) to another (the borrower); and
- an obligation or an intention on the part of the borrower to repay that amount to the lender (which may be satisfied by the provision of an asset).
Examples of these transaction types include a margin lending account or bank overdraft once drawn upon or a secured or unsecured loan.
Following this logic, offsetting an overpaid present entitlement against a capital redemption will result in a borrowing and breach of s67 SIS.
How to Treat an Overpaid Present Entitlement
Ideally, the Fund records the overpaid present entitlement as a credit in the financials without any intention to repay it, and the following documents do not exist:
- Loan agreement
- Interest calculation to be paid by the Fund
- A contractual agreement that the Fund has to repay the credit
Classifying the liability as an “Overpaid Present Entitlement” and not as a loan will help reduce the number of queries from SMSF auditors.
At the end of the year, the Fund’s beneficiary account is expected to reduce as its present entitlement to current distributions accrues.
When is an Overpaid Present Entitlement a Borrowing?
When an arrangement not described as a borrowing exhibits the necessary characteristics of a borrowing, it results in a contravention of subsection 67(1).
A good example is where no intention of a loan or borrowing develops into one because of later choices made by the trustees, such as repaying the credit or not reducing the overpayment by the present entitlements.
Providing an exhaustive list of conditions for classifying a credit as a borrowing is impossible and impractical.
What is Happening in the Fund?
The arrangement leading to the credit is not the only relevant consideration, as all of the Fund’s circumstances are important.
Is the overpayment because the Fund has cash flow issues and cannot pay expenses or the minimum pension?
An overpayment made as a one-off payment should trigger alarm bells and invite greater scrutiny of the Fund’s overpaid present entitlements and activities.
Has the unit trust paid the overpaid present entitlements proportionately to each related party unitholder?
Where overpayments made to related parties in an r13.22C unit trust are more than the proportion of units held, the Fund has effectively provided a loan to a related party.
In line with the requirements of r13.22D SISR, the overpayment is not at arm’s length, and the exemptions in r13.22C SISR no longer apply.
The unit trust is effectively busted and has to wind up, which is complicated where the trust owns business real property leased to a related party.
Several conditions must be in place for an SMSF to receive a complying overpaid present entitlement that is not a borrowing: it is generally paid annually, distributed proportionately to all unit holders and netted off against present entitlements each year.
There may be other reasons why an SMSF receives an overpaid present entitlement, which is why all the facts and circumstances of the Fund are relevant and reviewed.
SMSF professionals should be aware of the pitfalls of how an overpaid present entitlement can quickly turn to compliance custard and carefully monitor their SMSF clients’ situation in each subsequent year.
Like anything to do with an SMSF, it depends.
By Shelley Banton, head of education, ASF Audits