SMSF in-house assets

The Cooper Review into Australia’s superannuation system recently pointed out that in 2008, only 2.4 per cent of self-managed super funds (SMSFs) held related party investments, yet breaches of the in-house asset rules represented 16.3 per cent of all contraventions reported. This highlights the need for trustees making related party investments to be aware of their obligations under these rules, and equally to understand the types of investments that are specifically exempt from the definition of an in-house asset.

Complying with the in-house asset rules

The level of in-house assets that a SMSF can hold is currently limited to 5 per cent of a fund’s overall asset value. This test applies at the end of each income year using the market value of all in-house assets at that time, as well as at any time that a new in-house asset is acquired.

Where a SMSF exceeds the 5 per cent limit at the end of an income year, the Superannuation Industry (Supervision) Act 1993 (SIS Act) requires the trustee to prepare a written plan to dispose of one or more in-house assets at least equal to the value by which the 5 per cent limit was exceeded. This action must occur during the following income year. However, the Australian Taxation Office (ATO) has indicated that where market movements of the fund’s assets correct the breach during the following year, disposal of one or more in-house assets may not be needed.

What is an in-house asset?

The basic definition of an in-house asset is one of the following:

• a loan to or investment in a related party of the fund;

• an investment in a related trust of the fund; or

• an asset subject to a lease arrangement between the trustee and a related party of the fund.

There are, however, a number of exemptions from the definition of an in-house asset. A number of exemptions a SMSF may take advantage of include:

• business real property that is leased to a related party on an arm’s length basis;

• investments in non-geared related unit trusts or companies that meet a range of strict requirements;

• some investments in related unit trusts and companies that were set up prior to 11 August, 1999;

• loans made to a related party prior to 11 August, 1999;

• assets that have been leased to a related party continuously since before 11 August, 1999; and

• investments in a widely held unit trust (eg, managed fund).

It should be noted that an asset owned by a SMSF with a related party as tenants in common will not be an in-house asset simply because the SMSF and its related party share ownership. In this case, it will depend whether the asset owned is itself an in-house asset.

Related party

Understanding an SMSF’s related parties is often the key to a trustee complying with the in-house asset rules. A related party is:

• any member of the SMSF;

• a standard employer-sponsor of the SMSF (if any); or

• a Part 8 associate of any fund member or standard employer-sponsor.

A Part 8 associate (named because it comes from Part 8 of the SIS Act) of a SMSF member includes a relative, business partner (including their spouse and child), the trustee of a trust controlled by the member, and a company sufficiently influenced by the member or in which the member holds a majority voting interest.

Importantly, to determine whether a member controls a trust, or sufficiently influences or has a majority ownership of a company, the interests of the member and of their Part 8 associates are used.

For example, if a SMSF member’s relatives hold more than 50 per cent of entitlement to capital and income of a fixed trust, the trust will be a related party of the SMSF even though the member has no direct ownership in the trust.

Investment in certain non-geared unit trusts and companies

The non-geared entity exemption broadly aims to provide a more flexible way for SMSFs to purchase and hold real property jointly with other related parties. Instead of a SMSF purchasing a property directly under a tenants-in-common arrangement (which has some drawbacks), this exemption involves the SMSF and related parties purchasing, for example, units in a unit trust, with the trust then purchasing real property. One of the key benefits of this structure is that it will generally allow the SMSF to increase its ownership over time by acquiring further units or shares from the existing related party owners. This is allowed because of a specific exemption from the general rule prohibiting a SMSF from acquiring assets off its related parties.

An investment by a SMSF in a non-geared entity that meets the rules set out in SIS Regulation 13.22B or 13.22C is not an in-house asset. The rules are designed to significantly limit the activities of the trust or company, and include the requirement not to:

• borrow or allow a charge over any assets;

• run a business;

• hold an interest in another entity (eg, a unit trust would not meet this exemption if it held units in another trust or shares in either a listed or private company);

• loan money to another entity;

• lease an asset to a related party, except if the asset is business real property;

• acquire an asset from a related party of the SMSF after 11 August, 1999 (except if business real property); or

• acquire an asset that has previously been owned by a related party since the later of 11 August, 1999 and three years before the SMSF first invests in the entity.

The conduct of the trust or company is critical in this instance because any breaches any of the above requirements will bring the exemption to an immediate end and any interest held by the SMSF (regardless of when acquired) will become an in-house asset.

Penalties and anti-avoidance

A range of penalties may apply where the in-house asset rules are breached, including a trustee being required to take certain action to rectify a breach, fines, or (for serious breaches) imprisonment. The ATO may also deem the fund to be non-complying, a situation which may have major tax implications for the fund.

Breaches of the rules are likely to be viewed more favourably by the ATO where they are not intentional, they exceed the 5 per cent limit by a small amount and the trustee takes timely action to rectify the situation.

Anti-avoidance measures also apply to ensure that trustees who enter into a scheme to artificially reduce the value of in-house assets within a SMSF and avoid contravening the in-house asset rules can also be subject to a range of penalties.

Tim Sanderson is senior technical services manager at Colonial First State.