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A common SMSF breach and how to avoid it

The question often arises whether the SMSF is allowed to enter into a transaction with a member or a related party. This is a question that is of great concern to the ATO as it is also one of the most commonly breached areas of SMSF operation.  As a compliance focus it relates to whether trustees are meeting their obligations where loans, in-house assets, and non-arms length transactions are concerned.

The first step in ensuring that you don’t fall foul of these rules is to understand what is defined as a related party.  The SIS act defines a related party as any of the following:…

 

  • A member of the fund
  • A relative of a member
  • A standard employer-sponsor of the fund (this is an employer that contributes to the fund under arrangement with the trustee. It does not include contributions made under an arrangement with the member). This type of arrangement is relatively rare in modern trust deeds, however you should check your trust deed and associated minutes to ensure employers contributing to the fund are not considered employer sponsors.
  • A Part 8 associate of a member (this is a complicated area but will generally catch other members and trustees, people you are in a business relationship with, and people related to those people).  A Part 8 associate is not limited to individuals, but can include other entities where the member (or a group of people or entities related to the member) can significantly influence or hold a majority voting interest in those entities.

If that person or entity that you wish to enter into a transaction with is any of the above, you immediately know that you’re entering into the relatively grey area that is related party transactions. This is not to say that the transaction automatically cannot occur, but you should be aware that you will need to be especially careful before you proceed, and there may be limitations on the transaction even if it is able to proceed.

Example Of Related Party

Bill is a member and trustee of the Smith Family Superannuation Fund and he would like the fund to invest into a private unit trust set up to purchase a series of properties. The super fund would be one of 10 investors of which he would be one personally, as would his sister, his sister’s private company and her SMSF. These other entities and people would effectively own 55% of the trust units. For the purpose of determining whether a related party transaction is occurring, because these people and entities are Part 8 associates of Bill and the SMSF, the ownership will be grouped together. Therefore any investment by the Smith Family Superannuation Fund will be considered a related party transaction because this group effectively controls the trust.

Arms Length Transaction

It is important to understand that the law requires all transactions for an SMSF to be conducted on at arms length basis. Clearly for related party transactions this is not possible because the parties are in fact not at arm’s-length. The law has allowed for this in relation to SMSFs by stating that if the parties are not at arm’s-length, then they must act as though they are or on terms that do not disadvantage the SMSF. So if you are going to enter into a related party transaction you must ensure you do so without creating any special favours, terms, and the price paid is a justifiable market price.  If it does favour one party a little over the other, the favoured party must be the SMSF.

Acquisition Of Assets From A Related Party

There are also restrictions on an SMSF purchasing assets from a related party. In the example given above if a related party of Bill had already owned the units in the trust, Bill’s SMSF would not be permitted to purchase those units, even if the transaction was undertaken on an arm’s-length basis.

There are some exceptions to this rule which include:

  • the purchase of listed securities
  • acquiring business real property
  • acquiring an asset that is an in-house asset
  • acquiring an asset that would be an in-house asset except that it is exempted under the in-house asset rules.

In-house asset rules

The simplest way to think about in-house assets is to say that it is any asset/transaction that involves a related party. These are quite complicated rules and you should read section 71 of the SIS legislation for more detail. However, an in-house asset is basically:

  • investment in, or loan to a related party of the super fund
  • investment in a related trust
  • assets which are subject to a lease arrangement between the trustee and a related party

If the asset you are dealing with satisfies any of these descriptions, the SMSF is not permitted to hold more than 5% of its assets (in total, not per asset) in these types of assets. This can pose quite a problem where movement in valuation causes this 5% rule to be breached. In this instance the trustee will be required to dispose of in-house assets to bring the total value of in-house assets back below the 5% threshold. The law does not allow for other methods of solving this problem such as the making of contributions. This may effectively have the same result in terms of asset levels, but the law calls for assets to be sold to remedy the breach. (The ATO showed some leniency in regards to this rule during the GFC, however it would probably be dangerous to rely on that leniency continuing for any length of time.) This action must be undertaken within 12 months of the end of the financial year when the breach occurred.

As an example, if we consider Bill and his SMSF, the investment in the proposed unit trust, even though it is a related trust, would be possible under the in-house asset rules provided the total value of all in-house assets within his SMSF did not exceed 5% as a result of this transaction.

Exceptions To In-House Rules

There are a number of transaction types which would be considered in-house assets except for the fact that they are specifically excluded under the legislation. These include:

  • Investment in a widely held unit trust (for example, this may allow an in specie transfer of units in a managed fund that were previously held personally by the member)
  • Life insurance policies
  • Business real property (this is property that is solely for business purposes, whether by a related party of the fund or an unrelated party)
  • An asset that the regulator determines is not a in-house asset (to view these see section 71 of the legislation and the regulations that relate to that section)

Loans to Members and Related Parties

There is a very important distinction that needs to be made between lending money to an individual versus a related party of the SMSF. Lending to a member or relative of the SMSF is specifically prohibited by law. However, if for example the member ran their business through a company or trust (as opposed to be a sole trader), the SMSF could lend money to that related company or trust. Doing so would come under the in-house asset rules and be subject to the 5% limitation but provided these limits were not exceeded, then no compliance breech has occurred.

It is important to remember that provisions of superannuation legislation run concurrently, and satisfying one provision does not mean that you don’t fail another. So for example, if you were to lend your company money under the 5% limit, but do so on terms that are more favourable than would normally occur for such a loan, then you may well have breached the arm’s length requirements and the sole purpose test. So take care.

Summary

The related party transaction provisions are complicated. Perhaps they seem needlessly complicated but unfortunately, before they were included in the legislation, trustees tended to abuse related transactions for personal gain. The easiest solution for the regulators would be to strictly prohibit any type of related party matters, however this would be overly restrictive within a well run fund.

Basically, if the transaction you are considering involves other people or entities you are related to, be careful.  Even if you are able to proceed with the transaction, you may be subject to limitations concerning the size of the transaction relative to the size of your fund. You will also have to consider whether you have made similar types of transactions in the past, and the effect this has on the current deal under consideration.

So it’s not an easily understood part of the law, which may explain why it is also one of the most common compliance issues the Regulator deals with.  However, if you understand it, you will find there is a fair degree of flexibility which you may find beneficial.

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