Legally acquiring assets from a related party seems almost too good to be true, especially when s66 SIS forbids it.
But the SIS legislation is cleverly drafted to ensure all the rules work together, meaning that SMSFs can acquire assets from a related party in limited circumstances.
Definition of s66 SIS
Under s66 SIS, an SMSF must not intentionally acquire an asset from a related party.
Some exceptions exist. They come with the mandatory condition that an SMSF must acquire these assets at market value in line with r8.02B SISR:
- Listed shares on an approved stock exchange or licensed market
- Business real property (BRP)
- An in-house asset (IHA) that does not result in acquiring more than 5% of the fund’s assets
- Other assets excluded from being an IHA under s71 SIS, such as widely held trusts and r13.22C trusts
- Life insurance policy from a related party (not from a member or relative of the fund)
- Relationship breakdown
Listed shares include shares, units or bonds listed on an approved stock exchange acquired at market value. Problems arise when they are transferred from the member personally to the fund via an in-specie contribution.
The transfer occurs when the off-market share transfer form is executed (i.e. date the form is signed), regardless of the final transfer date to the share registry. Depending on the year it was intended, this may cause contribution cap issues at the end or beginning of the financial year.
Additional care is required to ensure the transfer is done promptly. Cherry-picking the best price (tax-wise) and working backwards so there is a ‘processing delay’ by the share registry indicates the shares were not acquired at market value resulting in a breach of s66 SIS.
Business Real Property
While BRP can be transferred into a fund by direct purchase or in-specie contribution, LCR 2021/2 has thrown the SMSF industry a non-arm’s length income (NALI) curve ball.
The reason is that paying the market price through cash and in-specie contribution can invoke the NALI provisions. As a result, the process and documentation associated with these in-specie contributions are critical.
For instance, BRP has an independent market valuation of $1m, with the fund paying $800k in cash and the other $200k paid by an in-specie non-concessional contribution.
According to LCR 2021/2, this represents a mismatch.
The ATO’s view is that the difference between the $800k paid in cash and the $1m market value does not represent an asset transferred into the fund. As a result, the SMSF has purchased an asset at less than market value.
Under these circumstances, the fund incurs non-arm’s length expenditure with any income from the BRP classified as NALI forever, along with any capital gain on disposal.
For the acquisition to be compliant, the sales contract must specify that the fund is only buying part of the asset: $800k for 80% of the investment.
A separate in-specie contribution of $200k for 20% of the investment occurs on the same day through a separate transfer document.
While the acquisition involves two entirely separate interests, it continues to comply.
s71 SIS does not allow a fund to invest in an IHA 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.
The link between s66 SIS and s71 SIS sets up a unique relationship for SMSFs to acquire an IHA from a related party as long it does not exceed the 5% IHA level.
A typical example is that a fund can acquire unlisted shares from a member in a related company but not shares from a member in an unrelated company (refer to our previous article on employee shares).
Other exempted assets such as BRP, widely held trusts and r13.22C entities are not limited by the 5% IHA level as long as they are acquired at market value.
Understanding the definition of BRP can be challenging. A case in point is that land and fixtures are considered BRP and allowable, but furniture is not and will breach s66 SIS.
An SMSF can acquire a life insurance policy from a related party, such as an employer sponsor. It cannot, however, acquire a policy held directly in the name of a member or relative unless there has been a relationship breakdown (refer to below).
An SMSF paying premiums for a policy held in the member’s name or a relative is a breach of s65 SIS because the SMSF is providing financial assistance to a member.
While the policy cannot be transferred into the SMSF, the member has to repay the cost of the premiums. A new policy must be taken out in the SMSFs name, noting the member as the insured.
An SMSF must meet specific conditions to acquire assets from a related party through a relationship breakdown. There are particular conditions to be met, and the rules of the Family Law Act 1975 apply:
- The member and their spouse have to be separated
- There can be no reasonable likelihood of cohabitation
- The acquisition is purely because of the breakdown (under these circumstances, the receiving SMSF can accept a life insurance policy from the exiting member even though it is technically a breach of s66 SIS)
Merger Between SMSFs
Merging two SMSFs does not mean combining all the assets without consequence. As they are considered related parties, the same exceptions apply to a merger as to any other fund.
The newly merged fund can only acquire assets that include listed shares, BRP, widely held trusts, r13.22C entities and IHA (up to the 5% limit).
Prohibition of Avoidance Schemes
Section 66(3) SIS prohibits SMSF trustees from entering into an avoidance scheme to acquire assets from a related party.
The definition of who is a related party becomes essential in terms of control and sufficient influence.
By way of example, if an SMSF owns 50% of an interposed entity with an unrelated party, the fund does not own a majority, and the entity is not a related party.
But if the entity purchased residential property from a related party, which it could not do if it were an r13.22C entity, the question of control arises.
Has the fund sufficiently influenced and controlled the investment decision with the other investor in place as window dressing? Under these circumstances, the interposed entity is related, and the residential property becomes an IHA of the fund.
There are many ways in which SMSF trustees can fall foul of the SIS rules. The key is understanding s66 SIS thoroughly and triaging each scenario to ensure that an SMSF can legally acquire assets from a related party.
Alternatively, the effects and consequences can be dire and have far-reaching tax and compliance implications for SMSFs.
Not rushing into a transaction and undertaking robust due diligence will ensure that SMSF trustees get it right the first time.