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SUPER AND BANKRUPTCY: PROTECTING YOUR NEST EGG

Contributed by Bryce Figot, Lawyer, DBA Butler Pty Ltd.

Superannuation represents the largest asset for many Australians. However, with tough economic times, bankruptcy and other insolvency activities are on the rise. In the September 2008 quarter there were 9,007 instances of total personal insolvency activity (including 6,693 new bankruptcies). This is an increase of 12.57% against the same period in 2007/08 (Insolvency and Trustee Service Australia, "Provisional Personal Insolvency Statistics" (Press Release, 8 October 2008)).

An important question, therefore, becomes: how is superannuation treated upon bankruptcy? To properly answer this question, it is vital to understand what the former bankruptcy provisions were and how they have recently changed.

The bad old days: the former bankruptcy provisions

Not so long ago, all property that belonged to a bankrupt at the start of the bankruptcy was divisible among the creditors of the bankrupt (Bankruptcy Act 1966 (Cth) ("BA") s 116(1)). This raised the tricky question: was an interest in a superannuation fund "property"? Bankruptcy legislation expressly answered this question with a no: the interest of a bankrupt in a regulated superannuation fund was not property divisible among creditors (BA s 116(2) (d) (iii) (A)).

However, this protection of superannuation was not absolute. The amount of a bankrupt’s interest in a superannuation fund that exceeded the pension RBL did constitute property that was divisible among creditors (BA s 116(5)). For example, in the 2007 financial year, this typically meant that only the first $1,356,291 of a bankrupt’s superannuation interests was protected. Anything over that amount was generally available to creditors.

The law on undervalued transactions was also a sticking point. If a person transferred property within two years before bankruptcy for no consideration, or less than market value, the property could be "clawed back" by creditors (BA s 120(1)). This raised the question: is a contribution by a member to a superannuation fund for consideration? If so, what is the consideration that the member receives and is the consideration less than market value?

Recent changes

Simpler Super

The simpler super reforms marked a large change for superannuation upon bankruptcy. The main change was the deletion of the provision in the bankruptcy legislation that effectively provided that the excess over the bankrupt’s pension RBL was available to creditors. This means that the protection of superannuation upon bankruptcy is now – subject to the discussion below – absolute. A bankrupt can now have an extremely large amount in a superannuation fund – even $1b theoretically – and this amount can be fully protected.

The government officially described the changes as follows:

"Currently, under the Bankruptcy Act 1966, a bankrupt’s interest in a superannuation fund up to the bankrupt’s pension RBL is protected from being divisible amongst creditors. A bankrupt’s superannuation interest in excess of the pension RBL automatically vests in the bankruptcy trustee.

The amendments remove references to RBLs from the Bankruptcy Act 1966 to ensure consistency with the new Simplified Superannuation rules which abolish RBLs with effect from 1 July 2007. This means that, from 1 July 2007, a bankrupt’s entire interest in a superannuation fund is protected from being divisible amongst creditors". (emphasis added)

(explanatory memorandum, Superannuation Legislation Amendment (Simplification) Bill 2007 (Cth), p 26.)

Cook v Benson

The High Court decision of Cook v Benson ("Cook") (2003) 214 CLR 370 considered the case of Peter Benson who became entitled to a lump sum from a superannuation fund. Shortly before becoming bankrupt, Benson rolled that money into other superannuation funds. Benson could have used that money to "have purchased a sports car, a recreational boat, a block of land or some other asset which ... [and if he had done so] it would have been available to his creditors upon his subsequent bankruptcy" (p 387).

The High Court considered whether the trustees of the superannuation funds that received moneys had given "valuable consideration" for the moneys they received. The majority held that the trustees had given valuable consideration (p 384). The consideration was the valuable covenants, duties and obligations assumed by the trustees of funds (e.g., obligation to provide insurance, pay retirement and death benefits, be bound by the terms of the deed etc).

The important implication of this case is that if a person transfers property to the trustee of a superannuation fund (even if it is only one day before bankruptcy) the property cannot be "clawed back" by creditors pursuant to the "undervalued transaction" provision. This is because it is not an undervalued transaction (i.e., the member received valuable consideration for the transfer). There were other provisions of the bankruptcy legislation as it then was that could be used to try to claw back the property (see, for example, s 121 of the BA). However, these provisions are often difficult to effectively use where a member receives valuable consideration.

In response to Cook v Benson, the bankruptcy legislation was amended. New provisions were inserted (see s 128A–128N of the BA) that effectively mean a contribution to a superannuation fund can be "clawed back" if the transferor’s main purpose was either to (BA s 128B (1) and 128C (1)):
  • prevent the transferred property being available to creditors, or
  • hinder or delay the process of making property available for division among creditors.
The new provisions provide a number of ways in which a main purpose is taken to be to prevent, hinder or delay.

One way it can be reasonably inferred that the member’s main purpose was to prevent, hinder or delay is if he or she was insolvent (BA s 128B (2) and 128C (3)). There is a rebuttable presumption of insolvency if the member fails to keep and preserve usual records, accounts etc to disclose their solvency (BA s 128B (5) and 128C (7)). These new provisions apply to any contribution to a superannuation fund after 27 July 2006 (BA s 128B (1) (d) and 128C (1) (f)). Consider an example where a member contributes to a superannuation fund on 28 July 2006 but then in 2026 no longer has records to disclose their solvency. If the member became a bankrupt in 2026, theoretically creditors can claw back the 2006 contribution from the superannuation fund. That is, there is a rebuttable presumption of insolvency. Unless the member can rebut the presumption, this means that the member’s main purpose is taken to be to prevent, hinder or delay creditors and thus the contribution can be clawed back ... even 20 years after the contribution! The point here is that it is vital to make records, accounts etc and to keep them!

Another way the main purpose can be reasonably inferred is where the contribution is "out of character" (BA s 128B (3) and 128C (4)). Consider a member who contributes $100 each every week for 20 years to a superannuation fund and then becomes bankrupt. The $100 that he or she contributed in the week before bankruptcy is not out of character and therefore is unlikely to have the main purpose of preventing, hindering or delaying creditors. Alternatively, consider a member who has only made one contribution ever and shortly after becomes bankrupt. It is far more likely that this would be held to be out of character. However, it may still be possible to argue that it was not out of character. For example, perhaps the member can prove that he or she has always wanted to contribute to superannuation but lacked free cash flow until that point in time and the bankruptcy was a mere coincidence.

Creditors are also free to use any other way they feel is appropriate to establish the main purpose in making a transfer (BA s 128B (4) and 128C (6)).

Self managed superannuation funds and bankruptcy

Remember that a "disqualified person" must not be a trustee of a superannuation entity (Superannuation Industry (Supervision) Act 1993 (Cth) ("SISA") s 121(1)). A disqualified person includes a person who is an insolvent under administration (SISA s 120(1) (b)) (which includes an undischarged bankrupt).

This means that if a person has an SMSF, they must resign/retire as a trustee (or director of the corporate trustee) before becoming bankrupt. Failure to do so can result in imprisonment for up to two years (SISA s 121(1)). After the person resigns or retires, the SMSF will probably fail to meet the basic conditions necessary to be an SMSF. This is because there will be a member who is not a trustee (or a director of the corporate trustee) (SISA s 17A (1) and 17A (2)). However, this is not necessarily fatal because the SMSF has a period of grace of up to six months in which to restructure (SISA s 17A (4) (b)). Restructuring can include rolling the bankrupt’s superannuation interests into a superannuation fund which is not an SMSF and then terminating the SMSF. Alternatively, it can involve appointing a RSE licensee to act as trustee of the SMSF (at which point the fund would stop being an SMSF and would become another type of superannuation fund). Although RSE licensees can be expensive, this is preferable where the fund has non-liquid assets that can not readily be rolled over into another superannuation fund.

A person who holds an enduring power of attorney in respect of a member can act as trustee of the SMSF instead of the member (SISA s 17A(3)(b)(ii)). However, this does not apply in respect of a member who is bankrupt (SISA s 17A (10)).

Benefits from superannuation funds

Subject to the discussion above, an interest in a superannuation fund is fully protected upon bankruptcy. So is any lump sum received from a superannuation fund (BA s 116(2) (d) (IV)). This means that a bankrupt, who receives, say, a lump sum of $10m from a superannuation fund, could keep that money in their own name so that all of that money would be unavailable to his or her creditors. Any money received from a superannuation fund by way of lump sum has, to put it colloquially, a halo around it.

The same is not true of pension payments received from superannuation funds. They are expressly denied the protection that interests in, and lump sums from, superannuation funds receive (BA s 116(2) (d) (IV)). Pension payments are treated as income (BA s 139L(1)(a)(i)) and income only receives minimal protection from creditors (BA s 139P and 139K and Social Security Act 1991 (Cth) Pension Rate Calculator A, point 1064 B1 Table B, column 3, item 2). The exact level of protection afforded to pension payments is adjusted for inflation twice a year, but as at 22 October 2008, the level is as follows (Insolvency and Trustee Service Australia):

Number of dependants Income limit
0 $41,250.30
1 $48,675.35
2 $52,387.88
3 $54,450.40
4 $55,275.40
More than 4 $56,100.41

Income in excess of the above limits is typically available to creditors.

The difference in the treatment between lump sums and pensions has important practical implications now that account-based pensions have been introduced. Account-based pensions are a new type of pension introduced with effect from 1 July 2007. Unlike other types of pensions, account-based pensions have no maximum periodic payment limit amount. With the old allocated pensions, there was a maximum amount of pension payment (Superannuation Industry (Supervision) Regulations 1994 (Cth) ("SISR") Sch 1A and 1AAB) and any money drawn in excess of that amount would be treated as a partial commutation (i.e., a lump sum).

Example

Consider Bill who is bankrupt, has no dependants and receives an allocated pension that was worth $1m on 1 July 2008. Bill was 60 years old on 1 July. Bill withdraws $400,000 from his allocated pension account. Only a maximum of $91,740 (this assumes that Bill started his allocated pensions after 31 December 2005 and thus Sch 1AAB applies instead of Sch 1A of the SISR) can be treated as a pension payment and, subject to his fund’s specific governing rules, the rest must be treated as a partial commutation lump sum. This means that of the $91,740 pension payment, only $50,489.70 (calculated as $91,740 - $41,250.30) is available to creditors and the $308,260 (calculated as $400,000 - $91,740) lump sum is fully protected.

However, if the trustee of Bill’s superannuation fund converts his allocated pension to an account-based pension, $358,749.70 (calculated as $400,000 - $41,250.30) is available to creditors.

Superannuation v discretionary trusts

It is worth noting that the recent case of ASIC, Re Richstar Enterprises Pty Ltd v Carey (No 6) (2006) 58 ACSR 141 has called into question the effectiveness of family discretionary trusts upon bankruptcy. This is an interesting development in light of the changes in respect of superannuation and bankruptcy.

Conclusion

Now, unlike the not-so-distant past, a person can have an unlimited amount of money in a superannuation fund and it is generally fully protected upon bankruptcy. The same is often true for contributions to superannuation funds; provided that the contribution is not out of character and that the member retains records to prove that they were solvent at the time of the contributions. SMSFs cease to be appropriate for those who are bankrupt. Provided benefits are structured properly, bankrupts can draw an unlimited amount from superannuation funds and those amounts are not available to creditors.

Source: CCH Tax Week, Issue 7, 19th Feb 2009
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