Binding death benefit nominations — Caution required on non-lapsing nominations

It is dangerous for an SMSF member to make a binding death benefit nomination that lasts for more than three years. Maddocks believes the law is inconsistent — in fact, that the law is internally contradictory. Therefore, Maddocks believes that to rely on a preferred, more flexible, possible interpretation is highly risky. Even after the recent ATO draft ruling, the inconsistency in the law remains. This article outlines the problem and urges caution.

Maddocks believes that the contradictions in the law on death benefit nominations mean that:

• SMSF trustees and their advisers should exercise extreme caution when considering allowing a member to make a binding nomination that does not strictly comply with the operating standards in regulation 6.17A(4). Those standards prevent a binding death benefit nomination from lasting for more than three years; and
• SMSF members should be equally cautious when considering making a binding nomination that does not lapse after 3 years. They could be exposing their SMSF trustee to claims from disaffected dependants in the event that the SMSF trustee follows a nomination that is more than 3 years old.

Maddocks' view is that this issue cannot be resolved until the Parliament amends the legislation to remove any ambiguity.

The contradictions in the relevant law

The law deals with binding death benefit nominations for SMSFs in two completely different sections. The two sections are contradictory. Also, only one of the sections can be interpreted in a way that says the three year limit on a binding death benefit nomination does not apply to SMSFs — but that interpretation is doubtful. The counter interpretation (that the three year limit does apply to SMSFs) is also persuasive.

Given this double dose of uncertainty, Maddocks believes that the sensible position to adopt is that the three year limit applies.

Here is a summary of the contradictory sections ... one of which is inconsistent. After the summary, we set out the law with some commentary

Approach 1 — relying on an inconsistency in the law, maybe the three year limit does not apply	Approach 2 — the three year limit applies
The general prohibition A super fund's rules must not allow anyone other than the fund trustee to exercise a trustee's discretion — see s59(1) of the Superannuation Industry (Supervision) Act 1993. Interim conclusion This general prohibition says that a member cannot bind a trustee at all. Qualifications There are two qualifications to the general prohibition. They are both in the section that contains the prohibition. One qualification suggests that prescribed standards, including a three year limit applies. The other qualification suggests that they do not apply to SMSFs. Qualification one — the three year limit applies The section with the general prohibition says it is "subject to section 1A". That section specifically says that the prohibition on restricting the trustee's discretion does not apply in relation to paying benefits after a member's death as long as the standards in the regulations are complied with. Those standards include the 3 year limit. Qualification two — the three year limit does NOT apply The section with the general prohibition says it does not apply to SMSFs. The uncertainty and doubt It is hard to know which of the qualifications takes priority over the other. To act on the basis that the three year limit does not apply is cavalier.	The general restriction If the benefits of a super fund member are cashed after the member's death, then this must be done "... in accordance with the standards prescribed for the purposes of section 31" — see s55A of the Superannuation Industry (Supervision) Act 1993. The "standards prescribed" The standards set out in regulation 6.17A(4) are the standards prescribed for the purposes of section 31. Those standards include the 3 year limit.
Sensible position Given that of the 2 approaches only half of one of them suggests that the 3 year limit does not apply, the sensible position to adopt is that the three year limit applies.
Consequences of taking the alternative position Arguably, making a binding death benefit nomination that does not conform to the prescribed standards will render the nomination invalid. Importantly, it would be invalid even before the 3 year limit had ended. If the nomination is invalid, then: the fund's trustee would have significant doubt about how death benefits should be distributed; and the trustee might be sued about how to exercise their discretion.
What about the ATO ruling? The principal focus of the draft ruling is really on to whom a deceased member's benefits may be paid — that is, the ATO is seeking to make it clear that death benefits can only be paid to the deceased member's legal personal representative or dependants. Although the ATO draft ruling takes the view that, the three year limit does not apply to SMSF death benefit nomination (on the basis outlined in the left hand column above): the ATO's draft ruling is only a draft; the ATO's view is not binding, it is not law; and the ATO's draft ruling does not deal with the approach outlined above in the right-hand column.
More information You can read: the relevant sections below along with our commentary on the law; and our more detailed analysis of the ATO's draft ruling — and the risks of following it.

The law

The relevant provisions of the superannuation law with respect to binding death benefit nominations are set out in sections 55A and 59 of the Superannuation Industry (Supervision) Act 1993 (SISA) and regulation 6.17A of the Superannuation Industry (Supervision) Regulations 1994 (SISR).

The law for Approach 1 — with its two inconsistent qualifications

Section 59 of the SISA states (italics added for emphasis):

(1)

Subject to subsection (1A), the governing rules of a superannuation entity other than a self managed superannuation fund must not permit a discretion under those rules that is exercisable by a person other than a trustee of the entity to be exercised unless... (there are certain exceptions which are not relevant to this article).

(1A)

Despite subsection (1), the governing rules of a superannuation entity may, subject to a trustee of the entity complying with any conditions contained in the regulations, permit a member of the entity, by notice given to the trustee of the entity in accordance with the regulations, to require a trustee of the entity to providing any benefits in respect of the member on or after the member's death to a person or persons mentioned in the notice, being the legal personal representative or a dependant or dependants of the member.

The relevant regulations referred to in section 59(1A) are set out in regulation 6.17A(4) of the SISR. Under the regulation, a binding death benefit nomination must:

• only specify persons to whom a death benefit would be paid who are either dependants or the legal personal representative of the RSF member¹
• specify the proportion of the death benefit that would be paid to the beneficiaries²
• be in writing and be witnessed by 2 adults who are not referred to in the nomination³
• be in effect (which means that it must not be more than 3 years old)⁴.

The law for Approach 2 — which supports the conclusion that the 3 year limit applies

Section 55A of the SISA states:

1. The governing rules of a regulated superannuation fund must not permit a fund member's benefits to be cashed after the member's death otherwise than in accordance with the standards prescribed for the purposes of section 31.
   
   
2. If the governing rules of a fund are inconsistent with subsection (1):
   
   (a)subsection (1) prevails; and
   
   (b)the governing rules are invalid, to the extent of any inconsistency.

Regulation 6.17A(1) provides that the standards set out in regulation 6.17A(4) (which are described above) are standards prescribed for the purposes of section 31.

In the absence of a binding death benefit nomination, the RSF trustee will generally have a discretion about how a death benefit is to be allocated, depending on what the RSF's governing rules state.

The uncertainty

The manner in which the Exclusion is drafted creates uncertainty concerning whether and how SMSF members can make binding death benefit nominations. This uncertainty is created by:

• the ambiguity in section 59(1) and the lack of reference to SMSFs in section 59(1A); and
• the ambiguity between the exclusion in section 59 for SMSFs and section 55A.

In summary, SMSFs are not expressly excluded from the operation of:

• section 59(1A), which sets the standards for binding death benefit nominations; or
• section 55A, which sets the standards for the payment of death benefits.

SMSFs are excluded from the operation of section 59(1) by the words "other than a self managed superannuation fund". On one view, this means that SMSFs do not need to comply with the requirements of the SISR with respect to the form of a binding death benefit nomination (including the requirement that it expires after 3 years).

However, section 59(1) is "subject to section 59(1A)". Section 59(1A) sets the standards for binding death benefit nominations for RSFs (which includes SMSFs).

The Draft Ruling

Draft Ruling SMSFD 2008/D1 (Draft Ruling) concerns whether there is any restriction under the SISA on a SMSF trustee accepting from a member a binding nomination of the recipients of any benefits payable in the event of the member's death.

In summary the Draft Ruling states that:

• there is no such restriction because section 59 of the SISA and regulation 6.17A of the SISR do not apply to SMSFs;
• a nomination is not binding to the extent that it nominates someone who cannot receive a benefit in accordance with the operating standards set out in the SISR (which, according to regulation 6.17A(1) of the SISR are set out in regulation 6.17A(4)).

The Draft Ruling purports to be concerned about the rules that apply to SMSF trustees with respect to SMSF members making binding nominations. However, the principal focus of the Draft Ruling is really on to whom a deceased member's benefits may be paid — that is, the ATO is seeking to make it clear that death benefits can only be paid to the deceased member's legal personal representative or dependants.

Above we have highlighted the uncertainties in the provisions of the SISA with respect to the requirements for nomination of beneficiaries and the payment of death benefits. The ATO does not express any view with respect to these uncertainties. The ATO simply states that, due to the Exclusion, SMSFs do not need to comply with regulation 6.17A.

The ATO's view is interesting, but does not resolve the uncertainties because:

• the Draft Ruling (and any finalisation of it) is merely an expression of the ATO's opinion about the law and does not have the force of law; and
• the ATO will not be involved in any proceedings in which a binding nature of a death benefit nomination is questioned (although the ATO would be involved in proceedings concerning whether a death benefit is paid to a dependant and what type of dependant, because of the different tax treatments).

The risk of following the ATO's view

Simply following the ATO's view and making a binding death benefit nomination that does not comply with the standards in regulation 6.17A could result in the nomination being legally ineffective.

If a purported binding nomination made by a SMSF member is legally ineffective, then the SMSF trustee cannot simply follow it in any event. The SMSF trustee can take it into account, but will also need to consider all relevant circumstances, including whether there are dependants that are not nominated in the binding nomination.

If a SMSF member makes a non-lapsing binding nomination and which nominates some, but not all, of the SMSF member's dependants to receive death benefits and the member dies more than 3 years after the making of the nomination, a disaffected dependent could:

• claim that the nomination expired under regulations 6.17A(4)(d) and 6.17A(7) of the SISR;
• claim that:
  
  –the SMSF trustee was not bound to comply with the nomination, but instead was obliged to use their or its own discretion in deciding how the member's death benefit was to be paid; and
  
  –in exercising this discretion, the SMSF trustee should have had regard to the dependents' circumstances and, had the SMSF trustee done so, a share of the benefit should have been paid to a particular dependant.

Conclusion

In consideration of the above:

• SMSF trustees and their advisers should exercise extreme caution when considering allowing a member to make a binding nomination that does not strictly comply with the operating standards in regulation 6.17A(4); and
• SMSF members should be equally cautious when considering making a binding nomination that does not lapse after 3 years. They could be exposing their SMSF trustee to claims from disaffected dependants in the event that the SMSF trustee follows a nomination that is more than 3 years old.

Maddocks' view is that this issue cannot be resolved until the Parliament amends the legislation to remove any ambiguity.

Finalisation of the Draft Ruling

The period for comments on the Draft Ruling closed on 10 October 2008. Given this we expect that the Draft Ruling will be finalised shortly.

Questions

If you have any questions in relation to this article, or self-managed superannuation generally, please call Maddocks in Melbourne on (03) 9288 0555 and ask for a member of the Maddocks Commercial Team.

¹ Regulation 6.17A(4)(a) of the SISR
² Regulation 6.17A(4) (b) of the SISR
³ Regulations 6.17A(4)(c) and 6.17A(6) of the SISR
⁴ Regulations 6.17A(4)(d) and 6.17A(7) of the SISR