Does the absence of a related party lease arrangement impact an SMSF’s in-house assets ratio?
While many accept that business real property held directly in the fund without a lease automatically becomes an in-house asset, is this assumption correct?
Definition of an In-House Asset
s71 SIS does not allow a fund to invest in an in-house asset exceeding 5% of total fund assets that include:
- a loan to, or investment in, a related party of a fund
- an investment in a related trust of a fund
- an asset of the fund leased to a related party
It follows that a fund can invest in any of these in-house assets if the value of the in-house asset is 5% or less of the total fund assets.
Impact of s82 SIS
Under s82 SIS, SMSF trustees must take action when the market value ratio of a fund’s in-house assets exceeds 5% at the end of the income year.
Trustees must prepare a written plan that sets out the steps to dispose of one or more of the fund’s in-house assets to 5% or less before the end of the following income year.
The plan must specify the excess amount, and if the fund cannot dispose of assets to reduce the in-house asset level back to 5% or less by the following income year, the fund must dispose of the in-house asset to comply.
The stakes are high because property values typically exceed the 5% level, and the fund must sell the property to meet the requirements of s82 SIS.
What is a Lease Arrangement?
s71(g) SIS says that business real property subject to a lease, or a lease arrangement enforceable by legal proceedings, between a fund trustee and a related party is not an in-house asset.
It gets murky when no lease arrangement is in place, and many argue that the property becomes an in-house asset of the fund.
The devil is always in the detail because s71(g) hedges its bets. Here, the definition of a lease arrangement in s10(1) SIS is relevant to understanding what can and cannot be a lease arrangement.
According to s10(1) SIS, a “lease arrangement” means any agreement, arrangement or understanding in the nature of a lease (other than a lease) between a trustee of a superannuation fund and another person, under which the other person is to use, or control the use of, property owned by the fund, whether or not the agreement, arrangement or understanding is enforceable, or intended to be enforceable, by legal proceedings.
Absence of a Lease Agreement
A lease arrangement that encompasses “any agreement or understanding in the nature of a lease under which the other person is to use, or control of property owned by the fund” opens numerous opportunities for an informal or verbal lease arrangement to be in place and enforceable.
Whether the tenant is a related party or not is irrelevant.
The Effect of SMSFR 2009/4
SMSFR 2009/4 is the bible when it comes to explaining the core concepts in the definition of an in-house asset as defined in s71 SIS.
One of the examples in the ruling is regarding the use of machinery in a member’s business (refer to example 5, paragraph 120).
In this case, an SMSF owns a machine that Dorien (a related party) uses in his business. While there is no formal lease arrangement and no rent is paid, Dorien has possession of the asset, meaning the nature of the arrangement is similar to a lease despite the lack of a formal lease agreement.
The ruling concludes that the machine is subject to a lease arrangement while being used in Dorien’s business and is an in-house asset of the fund.
While the example does not explicitly refer to business real property, the same meaning should apply: a lease arrangement is in place where an SMSF grants exclusive or full possession to another entity and is enforceable.
s109 Arm’s Length Dealings
The absence of a formal lease agreement should not stop the fund from continuing to benefit from the arrangement as if there was one.
All transactions between the fund and the related party must be at arm’s length, with rent paid regularly in advance at market value and requiring an annual independent rental valuation.
Otherwise, the fund may be in breach of s65.
Unfortunately, it is impossible to determine the other conditions of a formal lease agreement, such as who pays what expenses and the rights and obligations of both parties.
The arrangement lacks essential details typically included and expected in a written lease agreement, which could result in a breach of s109.
Where a breach is identified and the value of the lease (not the property) meets one of the financial threshold tests, SMSF auditors must lodge an auditor contravention report with the ATO.
Of course, the other primary consideration is that the absence of a written lease arrangement may establish a connection between non-arm’s length expenditure and the income from the business real property.
And that is a path no one wants to go down.
When an SMSF owns business real property directly, the absence of a related party lease arrangement should not automatically lead to a breach of the in-house asset rules.
The reason is that the definition of lease arrangement provides flexibility, as evidenced by SMSFR 2009/4.
However, the absence of a lease arrangement could lend itself to a breach of s109, as it is impossible to confirm that all transactions between the parties are on commercial terms.
The best practice is to have a written lease arrangement that provides certainty for SMSF auditors and the ATO, who may have difficulty confirming that such an arrangement exists.
Such uncertainty may also give rise to the NALI provisions, which is the last thing an SMSF trustee wants or needs.