Related-party loans continue to be the most significant compliance issue for SMSFs. Tim Miller outlines regulations funds need to consider to ensure they do not fall foul of the current rules.
SMSF trustees transact with related parties on a daily basis. Let’s be honest, the first thing they see when they wake in the morning is a related party. The question is: are they aware of the restrictions and prohibitions attached to certain related-party dealings and, by extension, the consequences of doing the wrong thing?
The ATO has released its annual SMSF statistical report every year since 2008/09. This report gives us a yearly peak into asset classes, membership, trusteeship and numerous other statistics, but none more fascinating than an update on the number and types of contraventions lodged each year. While it is appropriate to acknowledge overall SMSF compliance is exceptionally high, with only 2 per cent of funds having contraventions reported every year, it is disturbing one contravention stands on top of the mountain without peer year after year.
Loans and/or financial assistance using fund resources to members or relatives of members has steadily increased every year since reports were first made available as the most contravened section of the Superannuation Industry (Supervision) (SIS) Act, and represented 21.5 per cent of all contraventions in the year to 30 June 2014.
It could be argued this number is only high because trustees are improving in other compliance areas more rapidly, however, it’s a fact this is a simple provision that prohibits lending to particular people, with no ifs, buts or maybes. So we should all be working to bring this number down.
What does the law say?
Section 65 of the SIS Act prohibits superannuation funds, including SMSFs, from providing financial assistance to members or their relatives.
“The trustee or an investment manager of a regulated superannuation fund must not:
- lend money of the fund to:
- a member of the fund; or
- a relative of a member of the fund; or
- give any other financial assistance using the resources of the fund to:
- a member of the fund; or
- a relative of a member of the fund.”
For the purposes of this article, but perhaps also as a handy reference, members and relatives will herein be referred to as related individuals. This is an important distinction because without doubt many of the compliance issues arise because a loan to a related party is considered an in-house asset under part 8, section 71 of the SIS Act and therefore subject to a 5 per cent investment restriction, however, section 65, which prohibits the lending or provision of financial assistance as highlighted above, states nothing in part 8 shall have any bearing on the prohibition. Related parties and the in-house asset rules are considered below.
The effect of this restriction not only means SMSFs are unable to lend money to related individuals, it also means related individuals cannot use fund assets without providing appropriate commercial consideration to the fund, such as paying commercial rent for the use of any direct property. In certain circumstances, the use of fund assets by a member or relative will be strictly prohibited, such as in relation to collectables and personal use assets. The important message is all legislative provisions must be reviewed when considering any SMSF transaction.
In theory, the use of SMSF fund assets by members or their relatives for no cost could be considered to be providing financial assistance to the related individual, but may also cause the sole purpose test and/or the in-house asset and/or the arm’s-length standards to be breached.
The ATO has issued a ruling, SMSFR 2008/1, on the application to SMSFs of the prohibition on giving financial assistance to members or relatives. The interpretation is extremely broad and when determining if financial assistance exists can also extend to interposed third parties or entities (that is, indirect assistance). This is where the link between the in-house asset rules and the loan-to-member rules starts to blur.
If a fund lends money to a related company, let’s say Super Investor Pty Ltd, it would appear on face value to be in accordance with the in-house asset requirements. If, however, Super Investor then on lends the money to a related individual, then it’s clearly in breach of section 65.
SMSF trustees should ensure they are aware of the contents of SMSFR 2008/1. This ruling was last updated to incorporate legislative changes, most notably the introduction of rules relating to collectables and personal use assets.
Further, the ATO has issued a taxpayer alert, TA 2010/5 “The use of an unrelated trust to circumvent superannuation lending restrictions”, in response to the emergence of arrangements designed to circumvent the lending restrictions.
In the ruling the ATO sets out a number of transactions or arrangements it would and would not consider as providing financial assistance.
Transactions the commissioner would consider to contravene the lending provisions are:
- giving a gift of an SMSF asset to a member or relative of a member;
- selling an SMSF asset for less than its market value to a member or relative of a member;
- purchasing an asset for greater than its market value from a member or relative of a member;
- acquiring services in excess of what the SMSF requires from a member or relative of a member;
- paying an inflated price for services acquired from a member or relative of a member;
- forgiving a debt owed to the SMSF by a member or relative of a member;
- releasing a member or relative of a member from a financial obligation owed to the SMSF, including where the amount is not yet due and payable;
- delaying recovery action for a debt owed to the SMSF by a member or relative of a member;
- satisfying, or taking on, a financial obligation of a member or relative of a member;
- giving a guarantee or an indemnity for the benefit of a member or relative of a member;
- giving a security or charge over SMSF assets for the benefit of a member or relative of a member.
Factors that assist in determining whether the law has been contravened would be:
- the arrangement or transaction exposes the SMSF to a credit risk, or exposes the SMSF to a financial risk, of a member or relative of a member;
- the arrangement or transaction is on non-arm’s-length terms that are favourable to a member or relative of a member;
- the arrangement or transaction is not a usual or normal commercial arrangement in the context in which SMSFs operate;
- the arrangement or transaction is not consistent with the investment strategy of the SMSF;
- under the arrangement or transaction an amount is paid by the SMSF, and later repaid to the SMSF, in amounts or in a manner that may be equated with the repayment of a loan
- whether with or without an interest component;
- the arrangement or transaction results in a diminution of the assets of the SMSF whether immediately or over a period of time.
At the centre of this problem is that we are dealing with related parties and the definition of a related party requires consideration. A related party of a superannuation fund is defined in section 10(1) of the SIS Act as meaning any of the following:
- a member of the fund,
- a standard employer-sponsor of the
- fund, or
- a part 8 associate of a member or a standard employer-sponsor of the fund.
For the most part what we are interested in here is the member and the associates of a member.
Part 8 associates
Part 8 associates of an individual can be summarised as follows:
- A company that is sufficiently influenced by the individual or the individual holds a majority voting interest in. This also includes companies influenced by other part 8 associates of the individual.
- A partner in partnership with the individual, including the spouse and or children of the partner.
- A trust where the individual (or part 8 associates of them) holds a fixed entitlement to more than 50 per cent of the capital or income, has a sufficient influence or has the ability to remove or appoint the trustee or a majority of the trustees.
- A relative of the individual defined as a parent, grandparent, brother, sister, uncle, aunt, nephew, niece, lineal descendant or adopted child of that individual or of their spouse, the spouse of that individual or of any other individual specified above.
Related party – in-house asset exception
The anomaly within the law is effectively an anomaly of time. It is conceivable an amendment to the law to reflect a clearer definition of an in-house asset by removing related individuals could assist in the problem. Even without a change in law, a change in mindset could achieve this.
As it currently stands, an in-house asset is defined as a loan to, or an investment in, a related party of the fund, an investment in a related trust of the fund, or an asset of the fund subject to a lease or lease arrangement between a trustee of the fund and a related party of the fund. The level of in-house assets permitted by the SIS Act is 5 per cent of the total fund assets.
Simply replacing related party with related company (or trust) assists in clarifying that loans to and assets leased can only be to an entity other than a related individual. Given that business real property is excluded from the definition of an in-house asset, no further definition change would be required there.
Link with collectables and personal use assets
June 2016 is fast approaching and with it comes the sunset clause on pre-2011 collectables and personal use assets. SMSFs that have acquired collectables and personal use assets post-July 2011 have been bound by fairly restrictive investment provisions. Prior to that date the laws were far looser. It is common knowledge trustees pushed boundaries, particularly regarding storage and use of certain assets.
Trustees who undertook investments in these asset classes prior to 2011 have just over a year to ensure their assets satisfy the investment rules and should ensure they are not receiving any financial assistance from their existing arrangement because it may go unnoticed at present, but once a post-2016 review is undertaken, a fund could find itself in a far worse position than the small monetary penalty for breaching the collectable rules.
It’s your money, but not yet
SMSFR 2008/1 is a timeless ATO reference guide, but one we need to take seriously. Perhaps the introduction of administrative penalties will assist and soon the slapping of a $10,200 penalty for taking a few hundred dollars out of the fund will abate this bad habit. Let’s just hope it doesn’t create a vicious circle of lending more money to pay the penalty.