Josh has been working in the financial services industry since 2007 in paraplanning and advisory support roles. Before joining IOOF in October 2015, Josh worked as a Provision of Advice Specialist for UBS Wealth Management.
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This article deals with some of the misunderstanding around the in-house asset rules and the related party acquisition rules in relation to SMSFs.
The combination of consistent growth in self-managed superannuation funds (SMSFs) and a desire for people to maximise their retirement benefits in an environment where investment returns are hard to obtain through some traditional asset classes, means many SMSF investors are turning towards alternative investments, such as private equity.
Those with existing exposure to these alternative assets can be tempted to consider using their SMSF to increase their exposure. This can cause them to inadvertently breach some of the rules SMSFs must follow.
Based on our recent observations, there is some misunderstanding around both the in-house asset rules and the related party acquisition rules. We will revisit these rules and consider how they interact in the case of certain alternative investments.
Under s71 of the SIS Act, restrictions are placed on super fund trustees lending money to, investing in, or creating a lease over a fund asset where the other party to the transaction is a ‘related party of the fund’. To understand whether an asset is an in-house asset, we need to look at the party who is receiving the loan, investment or lease, and then determine if that entity is connected to the fund.
A related party is defined within s10 of the SIS Act to mean any of the following:
1. A member of the fund.
2. A standard employer-sponsor of the fund – generally not relevant to SMSF arrangements.
3. A Part 8 associate of an entity referred to above in a or b.
This means we must consider the definition of Part 8 associates of the members of the fund, which is provided in s70B, to include:
1. A relative of the member, where a relative is defined in s10 to include parents, grandparents, siblings, uncles, aunts, nephews, nieces or children of the member or their spouse – or the spouse of any of those people.
2. Each other member of the fund and each trustee of the fund.
3. If the member is involved in a partnership, any other partners and the children and spouses of individual partners.
4. A trustee of a trust where the member controls the trust.
5. A company that is sufficiently influenced by the member, such as another entity that is a Part 8 associate of the member or a group thereof.
The control of a trust is further defined in s70E and considers whether a ‘group’ in relation to the member has a fixed entitlement to more than 50 per cent of the income or capital of the trust, or if the trustees are used to act under the directions of a group, or a group has the power to remove or appoint trustees of the trust. ‘Group’ in this context means the member themselves, a Part 8 associate, or any combination of the Part 8 associates and/or the member acting together.
Overall, the related party rules are designed to capture a wide group of people and entities that may be in a position to be directed by the member or operate in conjunction with the member. This is to prevent people using their SMSF to capture extraordinary investment gains in a concessionally-taxed environment.
In addition to the wide capture of who a related party of a fund may be, there are also a number of exceptions to the in-house asset rules. The following arrangements are not considered in-house assets:
A business real property subject to a legally-enforceable lease.
An investment in a widely-held unit trust.
Property owned as tenants in common with a related party.
A closely held unit trust established within the rules of SIS Regulations 13.22C, which broadly relates to ungeared unit trusts owning business real property.
A widely held trust is a unit trust where no fewer than 20 entities have fixed entitlements to 75 per cent or more of the capital or income of the trust. These exceptions provide some limited scope for a SMSF to enter into long-term financial arrangements with related parties. The most frequent exemption to the rule is the leasing of business real property.
Importantly, the in-house asset rules do not place a blanket restriction on the acquisition of any specific in-house asset. Instead, they act to ‘cap’ the amount of in-house assets a SMSF is exposed to at no more than 5 per cent of the total assets of the fund. At the end of each year, a SMSF with in-house assets must ensure the ratio of in-house assets to total assets is under this limit. If the limit is breached, the trustee must document and implement a plan which states what in-house assets are to be disposed to bring the fund back under the 5 per cent cap.
The legislation in s82 is very specific, the plan must focus on disposal of an asset – it is not enough to add additional capital or restructure the fund to attempt to satisfy the cap.
Example 1: Residential property
Pharrell operates a SMSF that owns a residential property and limited cash reserves. During the year, his brother, Basil, finds himself in a housing crisis and Pharrell agrees to lease the property in the SMSF to Basil until he can get himself ‘back on his feet’. Basil pays the SMSF a rent that is market rate and conducts himself as an arms-length tenant.
At the end of the year when completing the SMSF’s annual return, the auditor identifies the residential property is subject to a lease to a related party of the fund and therefore the property is treated as an in-house asset under s71.
Compounding the pain, since the value of the property is greater than 5 per cent of the fund’s total assets, under s82, Pharrell must set out a plan to ensure that the in-house asset is disposed of within the financial year. Pharrell believes that if Basil moves out then no asset of the fund is subject to a lease with a related party. Sadly, however, the damage is done. The only rectification available to Pharrell is the sale of the residential property.
Related party acquisitions
Section 66 of the SIS Act also places a general restriction on SMSFs acquiring assets from related parties as previously defined. This restriction is not concerned with what the asset is, but rather who owns the asset the SMSF wants to acquire.
This restriction comes with several exceptions, which include:
listed securities acquired at market value;
business real property acquired at market value; and
certain in-house assets.
The last exception relating to in-house assets starts to blur the lines between the in-house assets rules and the related party acquisition restriction. This exemption provides that an in-house asset can be acquired, but only if the acquisition is completed at market value and would not result in a breach of the 5 per cent in-house asset cap.
Additionally, a super fund can acquire an asset from a related party that would be an in-house asset but for certain exemptions to the in-house asset test. In a SMSF context, this allows a widely held unit trust or 13.22C trust units to be acquired from related parties.
Unlike the in-house rules, the s66 restriction is a hard ‘ban’ on acquiring assets from a related party, unless an exemption is met. Further, there is effectively an anti-avoidance provision that catches schemes which would look to transfer an asset to an unrelated third party, and then have the fund acquire the asset from that third party. In these cases, the regulator has the power to ‘see through’ the transaction in determining whether the acquisition is a breach of the related party rules.
Combining these rules, we now have four scenarios a SMSF may encounter:
Acquiring an asset from a third party, where the asset is not an in-house asset.
Acquiring an asset from a third party, where the asset is an in-house asset.
Acquiring an asset from a related party, where the asset is an in-house asset.
Acquiring an asset from a related party, where the asset is not an in-house asset.
Scenario 1 is simple, it is how most SMSFs would be acquiring their traditional assets. No special SIS Act rules relate to assets acquired from third parties that are not in-house assets. Therefore, the fund is able to do as it wishes, subject to its standard trustee obligations, the SMSF trust deed and the fund’s investment strategy.
Scenario 2 is also relatively simple to adhere to. As the asset is owned by a third party, there is no restriction on acquiring the asset. However, since the asset meets the in-house asset criteria, the SMSF’s ability to continue holding the asset is subject to the 5 per cent cap.
Example 2: Related company purchased from third party
Nick is a member of a SMSF which has a total asset base of $2 million. One of Nick’s friends, Tim, previously made a small investment of $10,000 in a private company controlled by Nick. This company owns patents for specific medical devices. The company has successfully licensed the patents and Tim now wants to sell his investment. The current value of Tim’s holding is $80,000.
Nick does not have sufficient liquid funds to purchase the holding himself, however, he does have surplus cash in the SMSF and purchasing Tim’s holding would meet the SMSF’s investment requirements. Tim accordingly decides to sell his holding in the private company to Nick’s SMSF.
As Tim is not a related party of the fund, the acquisition is able to occur under s66, however, once the SMSF owns the asset, it now has an investment in a related party of the fund since the company is controlled by Nick. This $80,000 holding is therefore an in-house asset.
As the total value of the SMSF is $2 million, the company represents 4 per cent of the fund’s assets, so the cap is not breached by the acquisition. Nick will have to review this ratio each year and if it breaches 5 per cent, he will need to partially dispose of the private company shares.
The considerations in Scenario 3 are relatively simple. In-house assets can be acquired from a related party subject to the 5 per cent in-house asset cap.
Example 3: Purchasing units in related trust
James operates a cray fishing business and uses a SMSF to save for his retirement. The family trust owns a number of fishing licences and James believes these would make an appropriate investment for his retirement. The licences are currently owned through a unit trust, which is controlled by James.
The current balance of James’ SMSF is $1 million. In discussion with his administrator and adviser, he decides to have the SMSF purchase $40,000 worth of units he currently holds. The unit trust, being controlled by James, is a related party to the fund and so these units, if acquired by the SMSF, would be in-house assets.
Although the units are being acquired from a related party, because the asset is considered an in-house asset, it falls into one of the acquisitions from a related party exemption, so the transaction can proceed. James will have to monitor the ratio of in-house assets in the future to ensure the 5 per cent cap is not breached.
Scenario 4 can create some interesting outcomes. As the acquisition is being made from a related party, the restrictions in s66 apply. As the asset is not an in-house asset, the acquisition can only occur if the asset is business real property, a widely held unit trust or a 13.22C trust. When compared to Scenario 3, this seems to produce a strange outcome.
Example 4: Private equity investment
Susan has a family trust that made a private equity investment a number of years ago in a small medical company. The investment has performed very well. Susan is happy with the future prospects of the company but she wants to wind up the family trust and instead use her new SMSF as her primary investment vehicle. Susan therefore wants to sell the private equity shares to her SMSF.
The company is not a related party to the fund, as Susan or her Part 8 associates do not have any control or influence over the company – so the investment is not an in-house asset. However, as the family trust (being the current owner of the shares) is a related party to the trust, for the SMSF to acquire the shares it would have to meet one of the exemptions to the related party transfer rules. The company is not listed, nor is it specifically excluded from being an in-house asset, so no exemptions apply.
The SMSF cannot acquire the asset from the family trust, and if the SMSF acquires the same number of shares from a third party, and the family trust sells its shares to that same third party, the related party anti-avoidance provisions may be triggered which would result in a breach.
Overall, when advising SMSFs who want to acquire specific assets, it is critical to understand both the relationships around the asset and the current owner of the asset. Once that is established, both the in-house asset rules and the related party transfer rules must be applied to consider whether the SMSF is able to acquire the asset, and if so, whether the 5 per cent in-house asset cap will apply to the holding.