Trying to identify related party transactions in an SMSF can seem like pulling apart a set of Russian dolls: the first entity links to another entity, which, in turn, has another entity inside of it, and so on.
The question is how far do you continue searching to ensure that no related parties exist?
The reality is that when an ASIC search for an unlisted potentially related company reveals a group of shareholders that are companies or trustees for unit trusts, ASIC searches then have to be undertaken for each of those entities and when those shareholders are companies … well, it’s easy to see where this is going.
The basic rule of thumb is that related party transactions are rated high risk, so both the asset and any transactions will always be audited. The more information provided upfront will result in fewer queries and a more efficient audit — a win for everyone.
Here are 3 simple rules to help keep your funds compliant.
Acquisition of Assets from Related Parties
It’s essential that all dealings between related parties are done in conjunction with the fund’s investment strategy and trust deed. Remember, too, that the only assets a fund can intentionally acquire from a related party under s66 SIS are money or cash, listed shares, business real property and certain in-house assets.
While the definition of cash and listed shares are easy to define, there are 2 necessary conditions that business real property must satisfy prior to acquisition:
- The SMSF or the other entity must hold an eligible interest in real property
- The underlying land must meet the business use test, i.e. the real property has to be used wholly and exclusively in one or more businesses carried on by an entity (refer SMSFR 2009/1)
All acquisitions must be made at market value under R8.02B SIS with business real property being subject to a market valuation at least three months before the acquisition. The ATO recommends the use of a qualified independent valuer where the value of the asset represents a significant proportion of the fund’s value.
Once the asset is in the fund SMSF trustees can provide a valuation of the property in future years, but the hurdles are difficult to clear. They must be able to demonstrate that the valuation has been arrived at using a ‘fair and reasonable’ process, which should include an explanation to a third party (i.e. the auditor).
Related Party Income
SMSF auditors are required to strap their professional scepticism hats on at the beginning of every engagement.
When there’s a related party transaction either in the fund or in a related unit trust, the auditor will look at the investment in a different light. They will start by questioning whether the rent is being paid at market value and whether the terms of the lease are conducted at arms-length.
It’s best that an independent rental assessment is provided to confirm the rent is at market rates at the time of submitting the audit to avoid delays.
Any identified shortfall in rent may be a breach of s 109 SIS and reportable to the ATO. The timing of rent payments and all lease-related payments, such expenses, are also checked to ensure they’re in accordance with the terms of the lease and on an arms-length basis.
Where related party transactions are not on commercial terms and the fund is not worse off, this may also be reported in an auditor contravention report for not complying with s 109 SIS.
The NALI Effect
There can be significant tax implications for SMSFs from income-producing related party assets such as business real property, companies and unit trusts.
One of the most common examples is where the fund holds property, and the lessee is a related party. When rent is being paid at higher than market rates, a tax issue is generated as the investment is not being maintained on an arm’s length basis.
As a result, all of the income that the fund receives from that asset may be deemed as non-arm’s length income (NALI).
NALI is taxed at the highest marginal rate and applies regardless of whether the fund is in pension mode. Most importantly, it includes all of the income generated from the asset since the day of acquisition. Ouch.
From an audit perspective, NALI is not a compliance breach but a tax issue, which results in a management letter comment in most cases.
When related parties become part of the SMSF investment landscape, there are 3 simple rules that can help keep funds compliant.
The first one is to provide annual market valuation documentation demonstrating that all transactions are booked at current market value to comply with R8.02B SIS. The second is to ensure that all related party income is being paid at market rates and, finally, ensure transactions are undertaken on an arms-length basis to avoid NALI. Of course, the legislative complexities surrounding related parties mean more onerous obligations and responsibilities for SMSF trustees and their advisers. Keeping on top of it all is the key.