What happens in a SMSF breaches the laws?

SMSF compliance

Must the auditor report breaches of the super law?

What happens if a SMSF does breach the super law?

Consequences of a SMSF becoming non-complying

Common problem areas

Chapter 8 - Regulation of a SMSF

The Australian Taxation Office (“ATO”) is responsible for enforcing the SIS Act and other super laws as they apply to SMSFs.

If the SMSF’s deed is drafted properly and the trustees comply with the law, the SMSF will be eligible for tax concessions. These concessions can include a deduction for concessional contributions and concessional tax on the SMSF’s income. These tax concessions drive the SMSF’s enhanced investment performance. It is the tax concessions that make super such an attractive investment medium and allows it to outperform alternative investments.

Although theoretically onerous, trustees are normally able to satisfy these rules without any difficulty. The ATO is helpful, not obstructive and it is on the record as saying it will follow the standards set by its predecessor, the Australian Prudential Regulation Authority (‘APRA’). It is important not to overstate the risk of breaching the law. In most cases SMSFs run smoothly and difficulties are not encountered. Except for cases of extreme culpability, a SMSF that has inadvertently breached the super law will generally be deemed to have complied with the law by the Regulator. Where there is a minor breach of these rules, the Regulator generally uses its discretion to deem the SMSF to have complied with the rules.

What happens if a SMSF breaches the law?


A SMSF must be a complying super fund to get the benefit of the tax concessions extended to super funds. If a SMSF seriously breaches the super law it may become a non-complying fund and may lose the benefit of these tax concessions. It may also become liable for certain penalties, as may its advisers, particularly its auditors.

It is virtually unheard of for a SMSF to deliberately become non-complying. It just does not happen except in the most extreme cases, and this is a place few people choose to go to and one we definitely recommend you stay away from. Examples might include things like buying holiday homes in a SMSF – and then using them.

More common errors tend to be inadvertent. For example, a payment is misdirected or some other form of clerical error is made. The ATO is, sensibly, mostly forgiving when inadvertent errors are made leading to non-compliance. It rarely plays a hard hand provided the error is corrected and does not reoccur. The best option for a trustee where an error has been made is to fully disclose the error to the ATO (see below for further comment here).

SMSF compliance


The ATO does not issue annual notices that SMSFs are complying funds. Rather it issues an initial notice when the SMSF is first formed. Thereafter it only issues a notice if requested to do so by the SMSF, provided the ATO has not issued a notice under section 40 that the SMSF is no longer a complying fund and it is a non-complying fund. Therefore, once a SMSF is formed and has obtained an initial notice that it is a complying fund it continues to be a complying fund unless it receives a notice from the ATO saying it is a non-complying fund.

This means SMSF compliance is a ‘self-assessment’ system. The SMSF’s auditor plays a critical role. The auditor must certify that the SMSF has complied with the super law and this certificate is included in the annual return lodged by the SMSF with the ATO. If this certificate is not provided the ATO will issue a notice under section 40 that the SMSF is not a complying super fund.

The audit can be broken into two parts. The first part is a financial audit and this relates to the correctness of the financial statements and related documents. The second part is a compliance audit and this relates to the SMSF’s compliance with the SIS Act, and particularly whether the fund has not breached the various laws applying to SMSFs, for example, has not acquired an inappropriate investment, has not paid out member benefits in circumstances that breach the SIS Act.

Must the auditor report breaches of the super law?


This is dealt with in section 129 of the SIS Act.

If an auditor believes that the SIS Act has been breached the auditor must inform the trustee in writing of the breach. The auditor does not have to do this if the auditor honestly believes the trustee is already aware of the breach, but a wise auditor will do so anyway.

The auditor must then report the breach to the Regulator if:

  1. the trustee does not comply with the auditor’s request for a report regarding the proposed or actual action to be taken in respect of the breach; or

  2. the auditor is not satisfied with that action.

What happens if a SMSF does breach the super law?


From time to time SMSFs will breach the super law. Usually these breaches are not deliberate and in effect excused by the ATO, provided they are disclosed and are rectified as soon as possible. We have not seen the ATO not use its discretion favourably.

In practice, it is important for the SMSF to be able to show that the breach was inadvertent, not deliberate, and was rectified as soon as practicable once the SMSF became aware of the breach. For example, way  back in the year ended 30 June 2000 a client SMSF with more than $1,000,000 lent the members’ daughter $20,000 on commercial terms to help buy a car. The SMSF believed this investment was valid, because the loan was less than 5% of the SMSF’s assets and therefore did not breach the sole purpose test. The SMSF did not realise that the investment would breach the rule against loans and other financial assistance to members. Immediately on being informed of the breach the SMSF arranged for the loan to be repaid. The auditors did not certify that the SMSF had complied with the law and specifically brought the breach to the ATO’s attention.

The ATO exercised its discretion in favour of the SMSF. It was satisfied that the breach was not deliberate and that the SMSF had done all it could to rectify the breach once it was discovered.

We expect that the situation would be different if the ATO had discovered the breach or if rectification had not been made.

Consequences of a SMSF becoming non-complying


The ATO have released a short video explaining the process they apply when a breach occurs.


If a SMSF ceases to be a complying fund it loses the tax concessions extended to complying funds and become liable to a tax charge equal to the highest marginal tax rate of the value of its assets, less un-deducted contributions. If a SMSF with $1,000,000 of assets becomes a non-complying fund it will face a tax charge of $490,000 (49%).

The logic behind the tax charge being the value of the SMSF’s assets less un-deducted contributions is that this effectively reverses the tax concessions previously applied to the contributions received by the SMSF. In most cases it will go further than this, since the contributions are taxed at 15% and are possibly subject to the 15% super surcharge. There is no adjustment for this, plus the underlying assets have probably increased in value, and this increase is subject to tax at 49% even though it may not have been realized. This makes the penalties very onerous indeed.

This is a serious penalty, and although it is rare, it explains Dover’s conservative stance on so many issues: it’s just not worth taking risks with SMSFs and their complying fund status. When it comes to SMSFs, choose any flavour as long as it is vanilla.

Common problem areas


A SMSF may breach the super law in any number of ways. In a paper on SMSFs delivered to the Taxation Institute of Australia, Chris Kestidis of Hall and Wilcox, Lawyers, identified the following problem areas:

  1. special income, a situation where the SMSF derives income from related parties, such as a company or a unit trust, on a non-arm’s length basis;

  2. in-house asset rules, particularly those for investments in geared unit trusts; and

  3. sole purpose test, particularly where assets have a second purpose of being available for use by members and family and friends.

The ATO also publishes the top compliance mistakes made by SMSF trustees every year. The report from 2014 highlights the top 10 contraventions:

6. Limited recourse borrowing
8. Regulation of an SMSF