One of the key attractions for having a Self-Managed Super Funds (“SMSF”) is the ability to incorporate its investments into your overall wealth creation strategy. Therefore, it is common for a SMSF to deal with people or entities that may be classified as related parties. While related party investments tend to make up only a small percentage of the total assets held by all SMSFs, they produce nearly 20%[1] of all breaches reported to the Australian Taxation Office (ATO), as the Regulator of SMSFs.
This highlights the importance of understanding the “in-house asset” rules and restrictions around related party transactions.
Who is a related party?
The definition of a related party can be quite broad, and can encompass individuals and entities that are not immediately obvious. A related party of your SMSF includes:
- all members of your SMSF;
- standard employer-sponsor (not as common these days with SMSFs); and
- any Part 8 Associates
The ‘Part 8 Associate’ derives its name from the Part 8 section of the Superannuation Industry (Supervision) 1993 Act (SISA), and includes:
- member’s relatives;
- business partners/partnerships (including their spouses and children);
- trustees of trusts controlled by the member; and
- any company in which the member owns a majority voting interest, or is in a position to sufficiently influence the board’s decisions.
Relatives includes a parent, grandparent, brother, sister, uncle, aunt, nephew, niece, lineal descendant or adopted child of the member or of his or her spouse and a spouse of any of these individuals. If a relative of yours holds more than 50% of the voting rights in a company, that company would be considered a related party of your SMSF, even though you have no direct ownership in the company.
What is an “in-house asset”?
Your SMSF can hold almost any type of asset but there are some particular rules around in-house assets. An in-house asset of your SMSF includes:
- an investment in a related party;
- a loan to a related party; or
- a lease of a SMSF asset to a related party.
No Loans to Members or their Relatives
SISA section 65 specifically prohibits a SMSF from providing any financial assistance to a member or their relative. This restriction applies to not only your SMSF providing cash or assets, but extends to providing security over the member’s benefits or the SMSF’s assets. This is a very serious breach and is the single largest compliance issue for the ATO, and accordingly the ATO targets this area each year in its annual compliance program.
How to comply with the in-house asset rules
The value of all in-house assets cannot exceed 5% of your SMSF’s overall asset value. This test is applied at 30 June each year, but importantly also applies during the year when new in-house assets are acquired or established. Section 83 of SISA requires you to ensure that any new in-house assets acquired during the financial year (together with the current in-house assets) will not result in a breach of the 5% in-house asset limit.
What if the 5% in-house asset limit is exceeded?
Where your SMSF exceeds the 5% in-house asset limit at 30 June of any year, you are required to prepare a written plan to dispose of one or more of the in-house assets to reduce the overall in-house asset value back to the 5% limit. Ideally, you would aim for under this limit to prevent a reoccurring issue in the following financial year.
Please note, while the ATO has indicated that where market movements of your SMSF’s assets in the following year may assist in correcting the breach (therefore no disposal of assets is needed), a written plan is still required.
Exemptions to the in-house asset rules
There are a number of handy in-house asset exemptions that allow your SMSF to still invest in, or with related parties and they include:
- business real property that is leased to a related party on an arm’s length basis;
- investment in, or loan to, a related unit trust or company made prior to 11 August 1999;
- assets that have been leased to a related party continuously since before 11 August 1999;
- investment in a non-geared related unit trust or company (see below for restrictions); and
- investment in a widely held unit trust (e.g. public unlisted property fund).
It should be noted that an asset owned by your SMSF with a related party as ‘tenants in common’ will not be an in-house asset simply because the SMSF and its related party share ownership, but will depend whether the asset owned is itself an in-house asset.
Investment in non-geared unit trusts and companies
Since August 1999, the only other alternative for your SMSF to invest in a related party unit trust or company (holding greater than the 5% in-house asset limit) is via the non-geared exemption under SIS regulation 13.22B and 13.22C. A SMSF investment using these provisions is not considered an in-house asset.
One of the benefits of the non-geared unit trust or company holding business real property, is it can provide flexibility of ownership between your SMSF and other related parties compared to direct ownership via tenants in common. Of course, you will need to consider the potential impact capital gains and stamp duty may have when transferring units or shares between parties.
However, these non-geared unit trusts and companies are significantly limited to what assets they can hold or activities they can undertake. The restrictions include not being able to:
- borrow or allow a charge over any assets;
- run a business;
- hold an interest in another entity (e.g. can’t hold shares in company);
- loan money to another entity;
- lease an asset to a related party, except if the asset is business real property;
- acquire an asset from a related party of the SMSF after 11 August 1999 except if business real property; or
- acquire an asset that has previously been owned by a related party since the later of 11 August 1999, and three years before the SMSF first invests in the non-geared entity.
Most importantly, if the non-geared unit trust or company breaches any one of the above provisions, then the exemptions under SIS regulation 13.22B and 13.22C ceases immediately, resulting in your SMSF’s investment in the non-geared unit trust or company being classified an in-house asset. This is regardless if the breach is rectified during the current or future financial years.
Penalties and anti-avoidance
Breaches of the in-house asset rules may result in the ATO issuing you, as trustee, a penalty of up to $10,200. This penalty must be paid personally (the SMSF cannot reimburse you).
For more serious breaches, the ATO may issue your SMSF with a notice of non-compliance, which can have significant taxation consequences. However, in our experience the ATO has taken a more favourable view when the breach has been unintentional and you, as trustee, have taken appropriate and timely steps to rectify the situation.
There are also anti-avoidance measures and penalties to ensure trustees do not enter into arrangements to circumvent the in-house asset restrictions, or to artificially reduce the value of in-house assets.
Other related party transactions
It is also common for related parties to deal with each other, namely when buying and selling assets between them. Section 66 of SISA outlines the following type of assets your SMSF can acquire from a related party:
- listed securities from an approved stock exchange (e.g. ASX)
- business real property
- in-house assets – where the value of the asset in conjunction with value of existing in-house assets held by the SMSF will not exceed the 5% limit at the time of acquisition
Please note life insurance policies are specifically excluded from the above list, so a member who holds a life insurance policy outside the SMSF cannot transfer it into the SMSF.
All transactions on a Arm’s Length Basis
It is important that all dealings between your SMSF and the related party are transacted on arm’s length basis. Particularly, as under SISA section 109, your SMSF can be no worse off for the transaction than compared to other related party. One way to ensure you are complying with this requirement is to seek an independent valuation prior to the transaction, or document your supporting evidence and reasons for the decisions.
While there are restrictions on what assets your SMSF can acquire, there is no restriction on what you or your related parties can acquire from the SMSF, as long as the transaction is completed on arm’s length basis. Caution is required here though, as the ATO also carefully monitor members attempting to access their super benefit early via undervaluing SMSF assets in the transaction process, only to realise a significantly higher value once outside the superannuation environment.
How can we help?
As can be seen, these rules are complex and you should always seek the advice before undertaking any transactions with related parties. If you would like to know more about how to get the most from your SMSF feel free to give Jason McLaren a call on 0418 800 363.
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The information contained in this article is general in nature and does not take into account your personal situation or objectives. You should not act on this information in any way before seeking professional advice.
[1] ATO Self-managed superannuation funds: A statistical overview 2011-2013, Table 26: Types of contraventions reported to the ATO; accessed from ATO website on 3 March 2014.
