Has a recent case changed industry practice?
A significant number of SMSF trustees invest in related unit trusts. More and more of these trusts are post 1999 non-geared unit trusts that meet the requirements in regs 13.22C and 13.22D.
Naturally, the unit trust trustees declare distributions to the SMSF trustees. SMSF trustees may want to reinvest those distributions in the unit trusts.
There has always been a strong preference to implement this with a ‘paperwork method’. This avoids having to transfer:
- $x of distributions from a unit trust bank account to a fund bank account and then
- $x of unit subscription price back from the fund bank account to the unit trust bank account.
However, the recent case of FCT v Interhealth Energies Pty Ltd  FCA 120 casts a question mark over this practice.
Support for ‘paperwork method’
The principle in Spargo’s Case (1873) 8 Ch App 407 states that if A owes B and B owes A then:
if the parties meet together and agree to set one demand against the other, they need not go through the form and ceremony of handing the money backwards and forwards.
The principle in Spargo’s Case holds that ‘it is exactly the same thing as if the sums due on both sides had been paid’.
The principle has been recognised many times, including by the ATO. Specifically, in SMSFD 2007/1 the ATO state:
… if an SMSF has requested that a … trust distribution amount be applied or dealt with in some way on its behalf, the SMSF is taken to have received that amount as soon as it has been applied or dealt with as requested. For example, if a … trust distribution amount is to be reinvested in the … trust respectively, the amount is received by the SMSF when the amount is appropriated for the purchase of additional … units… If a … trust distribution amount is to be set-off against a liability owing by the SMSF to the … trust … the amount is received by the SMSF as soon as the set-off happens.
However, mere journal entries by themselves will not be enough when implementing the paperwork method. Rather, there must be an underlying liability or a mutuality of liabilities which the book entries are treated by the parties as settling.
Regardless, Interhealth causes the need to review this practice entirely.
In 2000 an SMSF trustee acquired all of the units in a related unit trust.
In 2008 an enforceable undertaking was executed by the SMSF trustee specifying that:
- Unit trust distributions payable to the SMSF trustee had not been paid since 2003.
- The unpaid distributions totalled $134,933.82.
- The SMSF trustee would collect the distributions.
However, the SMSF trustee later submitted that the unit trust trustee ‘did not have the liquidity to pay the … distributions … It was, therefore, necessary for the unpaid trust distributions to be applied as consideration for the issue to [the SMSF trustee] of further units in the [unit trust], thus extinguishing the liability’.
Among other things, the question arose: has the SMSF trustee complied with the enforceable undertaking?
In considering whether the SMSF trustee had collected the distributions, Logan J held that the SMSF trustee ‘has done no such thing’. He declared that the SMSF trustee failed to collect the unpaid distributions and thus had breached the enforceable undertaking.
Interhealth opens the question of whether the principle in Spargo’s Case can apply to allow SMSF trustees to exchange distributions for more units without transferring cash. Interhealth did not expressly consider the principle in Spargo’s Case. But Interhealth seems to imply that such non-cash transfers are not allowable.
However, the background facts described in this article are a very brief simplification. There were many more facts, all arising against a backdrop of a relationship break down between the two SMSF members where ‘their antipathy one for the other was palpable, mutual and enduring’. There were instances of the SMSF trustee not acting honestly. No doubt this played a role in the outcome of the case. Hopefully a vanilla application of principle in Spargo’s Case to SMSFs and unit trusts will still be possible.
However, for the time being, it probably is best practice if all related unit trust distributions owing to SMSF trustees are paid in cash.
Further, SMSFR 2009/3 suggests that if the trust distribution is not paid promptly, it will constitute a loan from the SMSF trustee to the unit trust trustee. This might cause — among other things — in-house asset issues.
Accordingly, for the time being, it is also best practice to make related unit trust distributions not just in cash but also promptly after the end of the relevant financial year. Any reinvestment by an SMSF into the related unit trust should then be by way of cash payment.
Interhealth also serves as a reminder of a number of other key lessons. The following quotes are extracted from the case:
Importance of having a sole purpose corporate trustee
‘Mr Wilson ceased in October 2004 to be a director of [the corporate trustee of the SMSF]. Ms Hambrook attributed this cessation just to a need to replace [the company] as trustee of the [SMSF] because that company was also carrying on business in its own right. That is something a trustee of a SMSF should not do.’
Importance of the trust deed
‘A trustee’s most fundamental duty is to comply with the terms of the trust. In the case of [the SMSF trustee] its obligation is to comply with the terms of the deed governing the [SMSF], as varied.’
General law duties
‘[T]he trustee must act as would an ordinary, prudent man of business managing his own affairs … A trustee is also subject to a range of fiduciary duties. These include a duty of impartiality. A trustee also has a duty to invest money held on trust … [T]he investment power [should] be exercised in a way that is in the best financial interests of the beneficiaries of the trust.’
Supremacy of the SISA
‘In the case of inconsistency, the SIS Act obligations prevail over whatever is otherwise specified in the governing trust deed.’
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