Breaching the in-house asset rules is a common trap SMSFs fall into. Tim Miller examines the parameters advisers and trustees need to know about in order to avoid this situation.
An SMSF may invest in a wide range of investments. The manner in which an SMSF invests is determined by the fund’s investment strategy and trust deed.
The Superannuation Industry (Supervision) (SIS) Act imposes on the trustee of an SMSF a number of duties and restrictions that affect the fund’s investment activities. A fund that fails to comply with these investment rules may lose its complying fund status and not be entitled to tax concessions. Penalties may be imposed on anyone involved in breaches of the investment rules.
It is the purpose of a fund’s investments, not necessarily the nature of the assets, that will determine whether a fund can maintain or hold them.
Certain investments are often questioned due to their nature, but if those investments fit within the investment strategy of the fund and the investment strategy satisfies the legislative requirements, then the fund may maintain that asset.
The sole purpose test
The trustee of an SMSF must comply with the sole purpose test, which requires the trustee to ensure the fund is maintained solely for one or more of the core purposes, or for one or more of the core purposes and for one or more of the ancillary purposes. A fund that is not maintained exclusively for at least one of the core purposes fails the test.
Primarily, the test requires a fund to be maintained for the provision of benefits for the members when they retire or turn 65 or alternatively their beneficiaries if the member dies before retiring or turning 65.
The ancillary purposes provide for benefits to be paid on the satisfaction of conditions of release other than retirement, turning 65 or death before those conditions.
Consistent with the payment of benefit rules in the SIS Regulations, the provision of benefits approved as additional ancillary purposes include but are not limited to payments:
- in the event of a member’s hardship,
- on compassionate grounds, and
- on the member’s temporary or permanent incapacity.
Essentially, the sole purpose of the fund is to pay retirement or death benefits to members or member beneficiaries of the fund.
Sole purpose test factors and related-party investments
Of significance when measuring benefits received via fund transactions is who is receiving the benefit. Clearly benefits provided to members and related parties are more likely to raise issues as a potential current day benefit rather than satisfy the retirement objectives of the SMSF.
If you take the case of collectable and personal-use assets, the potential for personal enjoyment from investing in such assets and therefore the link to current day benefits is high. As such, trustees must now be able to show how investing in these assets constitutes a reasonable investment for the superannuation fund.
Therefore, the question that has to be asked when considering an investment that is an in-house asset, is whether the investment is for the benefit of the fund or the benefit of the related party. Having an understanding of all the terminology used and the trustee’s purpose in making an investment will assist in the decision to invest or not and whether that is via a loan or direct investment.
Understanding related parties
For an SMSF, the term related party is relevant for the purposes of defining whether an investment constitutes an investment in an in-house asset, as well as being relevant for the prohibition on the acquisition of certain assets by the fund.
A related party of a superannuation fund is defined as any of the following:
- a member of the fund or a part 8 associate of a member, or
- a standard employer-sponsor of the fund or a part 8 associate of a standard employer-sponsor of the fund.
- Sections 70B to 70E of the SIS Act define a part 8 associate in terms of an individual, partnership or company as the primary entity.
Broadly, part 8 associates of an SMSF are those entities that are relatives of the individual members, partners in partnership with those members, and companies and trusts that are controlled or majority-owned by the SMSF members and their extended part 8 associates.
In-house asset rules
For all investments made in an SMSF after 11 August 1999, an in-house asset is defined in section 71 of the SIS Act as:
- a loan to, or an investment in, a related party of the fund,
- an investment in a related trust, or
- an asset of the fund that is subject to a lease or lease arrangement between the trustee of the fund and a related party of the fund.
There are a number of terms within that meaning the ATO has clarified for the industry via SMSF Ruling (SMSFR) 2009/4 – “Self Managed Superannuation Funds: the meaning of ‘asset’, ‘loan’, ‘investment in’, ‘lease’ and ‘lease arrangement’ in the definition of an ‘in-house asset’ in the Superannuation Industry (Supervision) Act 1993”.
SMSFR 2009/4 is a useful ruling as its primary purpose is to interpret the definition of an in-house asset by providing definitions of the key words in the definition.
The key words within this definition beyond the definition of a related party are what constitutes an asset, what is considered a loan, what will be deemed an ‘investment in’ and the difference between lease and lease arrangement.
Asset is defined in subsection 10(1) of the SIS Act as “any form of property”, which includes currency. The tax commissioner’s widened meaning of asset within the ruling is “every type of right, interest or thing of value that is legally capable of ownership and encompasses both real property and personal property”.
Personal property includes all forms of property other than real property (land and interest in land) and can be tangible and intangible.
Loan is also defined in subsection 10(1) of the SIS Act as “the provision of credit or any other form of financial accommodation, whether or not enforceable, or intended to be enforceable, by legal proceedings”.
This definition extends the standard definition of loan, which we understand as a payment and repayment arrangement.
This extension includes financing arrangements. So beyond the lending of money it can also include instalment arrangements and payment deferrals.
Warning: it must be highlighted that while the definition of an in-house asset includes a loan to a related party, this does not extend to members or members’ relatives. Loans to members or their relatives are strictly prohibited.
The definition of ‘investment in’ first requires the term investment to be defined. By extending the definition of ‘invest’ as provided in subsection 10(1) of the SIS Act, we can then determine what is meant by investing in.
Subsection 10(1) of the SIS Act defines Invest to mean “apply assets in any way; or make a contract; for the purpose of gaining interest, income, profit or gain”.
Therefore, the first step is to determine whether the trustees of a fund have made an investment by using the assets of the fund, in most instances money, to gain interest, income profit or gain. Once satisfied that this has occurred, the next issue is whether that investment is ‘in’ a related party or related trust. These terms are defined further on.
An investment in a related party or trust is an investment in that entity for income, profit or gain, not a direct investment in the assets held by that entity.
A lease is an instrument/agreement that grants the use of property to another party in return for compensation. The main distinguishing factor of a lease is that it grants exclusive possession to the lessee (tenant), meaning for the term of the lease the tenant has the right to occupy the premises but also the right to exclude access to the premises to any other party, including the owner. This is applicable for land.
For personal property (non-real property), such as equipment, a lease will grant possession of that property to the lessee through a legally enforceable hiring agreement.
A lease arrangement means any agreement, arrangement or understanding in the nature of a lease between the trustee of a superannuation fund and another person under which the other person uses or controls 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.
Therefore, a lease agreement is like a lease, but may not have all the characteristics of a lease and is in effect a more informal arrangement than a lease.
Where an asset is leased or subject to a lease arrangement for part of a year, the full value of the asset is an in-house asset for the period it is leased or subject to the lease arrangement.
In-house asset rules
An SMSF is subject to restrictions on its in-house asset investments.
The in-house asset rules:
- impose a maximum limit of investments in in-house assets of 5 per cent of total fund assets based on market value,
- require a fund with in-house assets in excess of the 5 per cent limit as at the end of the financial year to dispose of the excess in accordance with a written plan,
- prohibit the acquisition of new in-house assets if the market value ratio of the fund’s in-house assets exceeds 5 per cent, and
- prohibit a fund from entering into any scheme that would avoid the application of the in-house asset rules.
For the purposes of determining the market value ratio of an SMSF’s in-house assets, the trustees must value all of the fund’s assets.
To loan or invest
Loaded with all this information, we turn our attention to the validity of an in-house asset investment and what course of action is better suited to SMSF trustees.
Firstly, we have to identify whether the investment satisfies the sole purpose test requirement. If we are comfortable the investment provides a genuine retirement benefit, then its nature as related is largely irrelevant. What becomes relevant is the value of that investment and its future.
Assuming an SMSF invests in a related company, then the question to ask is whether we are restricting the fund’s investment growth strategy. If the related investments growth outshines the fund’s other assets, the fund is limited in its capacity to prosper in this growth and a sale seems the likely outcome.
If on the other hand the fund lends to rather than invests in a related company, it may satisfy the fund’s investment income objectives and is less likely to be affected by growth in the company as the loan will likely reduce in time when measured against fund assets.
In-house assets will continue to be in the sights of the regulator, so maintaining them on a commercial basis is a must. The other imperative is asking these questions: is the transaction beneficial to the fund or is it only beneficial to the related party, and would anyone other than a related party have made that investment?