DBA Lawyers discuss the hurdles in proving financial dependency where grandchildren receive death benefits from their grandparents' SMSFs.
On the death of a grandparent, in order to be able to pay a super death benefit to a grandchild, and for the grandchild to receive it tax free, the most common test to satisfy is financial dependency on the grandparent.
Unlike an interdependency relationship, financial dependency does not require the two to live together.
Financial dependency of a grandchild on a grandparent will also open up the possibility of the very tax efficient scenario where the grandparent died aged 60 or over, with the super death benefit being paid by way of pension to the grandchild.
The tax efficiency of this position arises because, at the SMSF level, income generated by pension assets is broadly income tax-free, and at the recipient (grandchild) level, pension income received is income tax-free.
The meaning of financial dependency
The above discussion begs the question: what is financial dependency?
Case law tells us that financial dependency is a question of fact, and does not require that the other person had an obligation to support the first person.
Additionally, the fact that one person has income or separate wealth of their own will not necessarily mean they are not financially dependent on another.
Whether somebody is financially dependent on another is a question of whether there was actual "maintenance and support".
This article discusses the Australian Taxation Office view, which will be the first hurdle if one claims a grandchild to be a dependant of their grandparent.
It should be noted, however, that the Commissioner of Taxation's view does not necessarily reflect the law.
The Commissioner has not expressed a detailed view on financial dependency in a public ruling.
However, a number of private binding rulings (PBRs) show the use of the following test: "financial dependence occurs where a person is wholly or substantially maintained financially by another person".
It appears from this that being "substantially" maintained financially will be enough.
However, these rulings appear to go further, stating the test is also as follows: "if the financial support received by a person were withdrawn, would the person be able to survive on a day-to-day basis?".
If the financial support provided merely supplements the person's income and represents "quality of life" payments, then it would not be considered a substantial support.
What needs to be determined is whether or not the person would be able to meet their daily needs and basic necessities without the additional financial support.
It appears that after some elaboration in the rulings, a strict approach is taken.
But what has the outcome of the rulings told us? This article sets out where one should stand in the ATO's view.
Only the necessities of life are relevant
It was explicitly stated in PBR 18688 that "issues of 'quality of life' in terms of 'enjoying a reasonable standard of living' cannot be taken into account and are irrelevant for the purpose of determining whether the trustee can be treated as dependant."
Another PBR (64085) has shown that paying for social outings, medication, pocket money, chocolate, music CDs and "costs for football" will not count.
A further example is PBR 40376, where amounts spent "tended to be on luxury items such as entertainment, rather than the child's day to day living expenses".
Financial dependence was not made out. The ruling went on to state: "the person was not so much maintaining the child's standard of living, but rather improving it, hoping to give the child the best chance of a happy and successful life…"
Expenditure relating to school
Expenditure relating to schooling is naturally of interest in the question of a grandchild being dependent on their grandparent.
Again in 64085, the deceased's contribution in paying for school books, school lunches and school uniforms did not matter.
However, in 52530, payment of school fees was relevant in finding financial dependency, along with paying for necessary food, shelter and clothing expenses.
It remains to be seen whether paying private school fees alone, being significantly higher than government school fees, can go toward financial dependency in the ATO's view.
It seems a fair inference that the Commissioner would not count this, as it is not strictly necessary for a child to attend a private school.
Proportion is crucial
It has been reiterated in many PBRs that the financial support must be substantial. This has in fact been applied in a literal and numerical way.
For example, contributions toward a person have been described as not "significant" where they represented only a "factually small percentage of the value of the total annual income of the household during this period".
Other instances where financial dependency was not made out were where the "bulk" of the money for the rulee's living expenses came from welfare benefits.
In addition, if a grandchild lives in a dwelling along with others, any contributions made by a grandparent towards the associated expenses of the dwelling have to be prorated for the others living there before they can count towards support of the grandchild (PBR 57857).
Regularity and continuity is important
From all the rulings discussed, the ATO has required one to show reliance on regular and continuous contributions.
Therefore, a grandparent should be able to show that they financially met or substantially helped to meet the basic needs of the grandchild regularly and over a period.
Lack of evidence — the classic pitfall
Retaining evidence of a grandparent's expenditure on a grandchild will be critical to proving financial dependency.
Additionally, the rulings indicate that where expenditure is asserted but not itemised, it will be difficult to convince the Commissioner that payments went toward the daily essential needs of the grandchild.
A more generous case law position?
Certain tribunal decisions and case law suggests that at least partial financial dependency can arise where financial contributions were made that assisted a person to maintain their normal standard of living, even if that standard was above the necessities of life (Malek and Commissioner of Taxation (1999) 42 ATR 1203), and even if the person could have paid the expenses themselves (Bovaird v Frost [2009] NSWSC 337).
On its face, this a different position to that expressed in PBRs.
Expert advice should therefore be sought where one's particular facts do not produce a clear result.
Naturally, seeking to rely on a legal analysis and case law that conflicts with the ATO's view may result in scrutiny and a potential dispute.
A conservative approach would be to seek a PBR, but it is likely the Commissioner would apply the above tests. Upon a negative result of a PBR, an objection is possible.
If the result of this is also negative, one could appeal to the Administrative Appeals Tribunal or Federal Court of Australia. Naturally, the review and appeal process could be a costly and time-consuming path.
Conclusion
The position on financial dependency taken by the ATO is quite strict. Unfortunately for well-meaning grandparents, contributions that merely improve the quality of a grandchild's life may not be enough.
The Commissioner's view indicates that for a grandchild to be dependent on their grandparent, the grandparent must, over a period, regularly contribute at least half of the cost of the grandchild's daily necessities of food, shelter, clothing and (to take a conservative position) government school fees.
They must also be able to produce evidence of this. While PBRs do not bind the Commissioner in future, he is likely to continue to apply the same test.
Daniel Butler is the principal of DBA Lawyers, Bryce Figot is a senior associate and David Oon works as a consultant at the firm.
