This article was first published in selfmanagedsuper magazine in November 2020
When a Self-Managed Superannuation Fund (SMSF) considers acquiring an asset or making a new investment, there are several compliance rules and issues that need to be considered at the time of acquisition. For example:
- whether the asset can be acquired from a related party;
- does it fit within the fund’s Investment Strategy;
- will the investment be regarded as an in-house asset; does the acquisition meet the sole purpose test; and
- is the acquisition or investment permitted under the Trust Deed.
In addition to these considerations at the time of acquisition, the on-going and potential future compliance and audit requirements should also be factored in when the trustees are weighing up whether a particular investment is one that the SMSF should be making. Assets acquired by an SMSF can have additional layers of compliance when compared to using other non-super structures to acquire and hold an asset. These on-going compliance requirements, potential costs and hurdles should be understood by SMSF trustees prior to acquisition.
Let’s consider what these on-going compliance issues are for various types of commonly held SMSF assets.
One of the most popular asset types held by an SMSF is real estate, which presents several on-going compliance issues for SMSF trustees to be aware of. A few of these are discussed below:
- Year-end market value - The market value of real estate held by an SMSF must be considered by the trustee(s) each and every 30 June. SMSF trustees need to be aware of the potential on-going costs associated with determining and substantiating market value for real estate. Potential costs include the expense of obtaining an independent valuation or other forms of market value evidence and additional administration and audit costs for an SMSF that owns real estate. The Australian Taxation Office (ATO) has recently released guidance on the evidence that SMSF trustees need to provide to their auditor to substantiate the market value used in the SMSF’s financial statements (search QC 64053 on the ATO’s website).
- Leasing real estate to a related party - Where the property is leased to a related party, trustees must ensure it continues to meet the definition of ‘business real property’ (BRP). There should be a review of the lease agreement to ensure that the terms are being adhered to, including any review to market of rents and that it has not expired. In addition to the initial costs to draft and execute a lease, there would be ongoing costs to extend, renew and vary the lease. This may include the cost of obtaining an independent assessment of market rental. Variation to a lease may also be caused by unexpected market conditions, for example the COVID-19 rent relief measures.
- Residential property - Where the property is residential, the SMSF auditor may require evidence that it has not been used by a fund member, relative or related party. This could be brought into question where the property is situated in a popular holiday destination and is leased out as holiday rental accommodation. An SMSF auditor may require the trustee(s) to provide evidence that the property has not been used by a related party and that this is provided at each annual audit.
- Charges over the property – The SMSF auditor may wish to conduct a search each audit year to ensure that the property has not been used to secure any borrowings, unless permitted. This may incur additional costs for the SMSF.
- Investment Strategy – It is not uncommon for an SMSF that owns real estate to have no other asset categories, apart from its bank account. The ATO and SMSF auditors have a focus on SMSFs with single asset investment strategies to ensure compliance with the requirements under SIS1. SMSF trustees need to be prepared to dedicate time to ensure that the investment strategy will stand up to audit scrutiny.
- LRBAs – Real estate held via a limited recourse borrowing arrangement (LRBA) is subject to certain SIS requirements. For example, the property cannot be developed. SMSF trustees need to be mindful of the limitations and restrictions of property held via a LRBA.
Units in a non-related unit trust:
A common scenario is where two or more unrelated SMSFs hold units in a unit trust and that unit trust acquires an asset, typically real estate. Each SMSF must not hold more than 50% of the issued units in the unit trust. This, together with other requirements, means that the SMSF’s investment is not treated as an in-house asset.
- Ongoing assessment of relationships – In addition to an initial assessment to ensure that a unit trust is not a related trust of each of the SMSF unit holders, there will be a requirement for an on-going annual assessment to ensure that this remains the case. This would include assessing whether there has been any change in circumstances that make members from different SMSFs related parties. For example, a member from each fund jointly acquiring a rental property together or children of members from each SMSF getting married to each other may mean they become related parties. The SMSF trustee should not be surprised if their SMSF auditor reviews the structure each and every annual audit.
- Exit plan - It is important that when this type of structure is entered into that the SMSF trustees are aware of the potential issues when one of the SMSF unit holders wants out, that is, to dispose of their units in the unit trust. The assessment of whether the investment is caught by the in-house asset rules is assessed from the perspective of each SMSF unit holder. A unit trust may be a related trust to one of the SMSF unit holders, but not another SMSF unit holder.
For example, a unit trust is set up with three unrelated SMSF unit holders (SMSF A; SMSF B and SMSF C), each holding one third of the issued units. SMSF C unit holder wants out and SMSF A offers to buy the units, at market value. From a practical perspective this achieves the desired outcome. However, there is now a significant compliance issue for SMSF A, as it now holds two thirds of the units in the unit trust. As SMSF A now holds more than 50% of the issued units, the unit trust is a related trust of SMSF A and caught by the in-house asset rules. From SMSF B’s perspective, it still holds units that represent not more than 50% of the issued units and consequently the unit trust is not a related trust of SMSF B. Assuming SMSF A’s unit holding value represents more than 5% of the total value of its assets, it will be required to dispose of the excess in-house asset amount by the following 30 June. This may cause issues, particularly where the asset held by the unit trust is the business premises of the business operated by members from one or more of the SMSFs. SMSF trustees in this type of non-related unit trust structure need to have an exit plan prior to executing the acquisition to deal with unit holders wanting to dispose of their interest, either voluntarily or involuntarily, e.g. a member passes away.
- Market value - As with real estate, SMSF trustees that hold units in a unit trust, or any other unlisted entity, will be required to determine and substantiate the market value each and every 30 June.
Division 13.3A unit trusts:
Another common scenario is where an SMSF acquires an asset via an interposed unit trust that complies with SIS regulation 13.22C in Division 13.3A, commonly referred to as a “non-geared unit trust”. This type of structure can be used where the SMSF is the sole unit holder or where the SMSF and a related party are the unit holders. Whilst the unit trust is prima facie a related trust of the SMSF, the SIS provisions exempt the units from being treated as an in-house asset, provided it complies with the requirements of SIS regulation 13.22C.
- Checklist of prohibited events - SMSF trustees need to be aware of the consequences where certain events occur after the structure has been established. These events are commonly referred to as 13.22D events and will cause the unit trust to be forever tainted as an in-house asset. A 13.22D event can occur simply by the SMSF buying listed shares with surplus cash. Rectification can be a challenge, as well as costly. The SMSF auditor will need to assess, each annual audit, that there have been no 13.22D events.
Two issues that arise where SMSF acquire assets overseas, particularly direct assets like real estate, is ownership and market value. Often local laws prohibit the asset being held by the SMSF and an interposed entity is required to hold the asset as a custodian or nominee, resulting in additional costs. Without relevant documentation, substantiating asset ownership can be a challenge.
Market value is also a challenge and may require engaging a local valuer to provide a market value report. Again, this may be more expensive than arranging a valuation of a property situated in Australia.
- Language used - Where documents are in a non-English language, translation costs may be incurred so that the accountant and auditor can understand them.
- Foreign currency translation - Where a transaction in relation to the overseas asset is in a foreign currency, there may be additional accounting and compliance costs associated with translating the amounts into Australian dollars and dealing with the related income tax consequences. Further, the SMSF may have an obligation to lodge local foreign jurisdiction returns and pay taxes.
Generally, the administration and compliance costs associated with an SMSF owning an overseas asset, like real estate, will be higher than where the asset is situated in Australia.
Collectables & Personal Use Assets:
The rules for an SMSF owning these types of assets are very prescriptive and are generally seen as a back-door prohibition on SMSF’s holding such assets. Commonly, when SMSF trustees are made aware of the ongoing compliance requirements of these types of assets, they decide to acquire the asset outside of their SMSF.
Forewarned is forearmed
Advice at the time an SMSF acquires an asset or makes an investment to ensure that the superannuation rules are complied with is important, but such advice should not end there. Where SMSF trustees have the knowledge and understanding of the on-going compliance requirements for different types of asset classes, preparation of the annual financial statements and conduct of the annual independent audit can run a lot smoother. It also prompts forward planning to deal with potential future events. In fact, it may even lead to the SMSF trustees deciding not to acquire the asset or make the investment. Educating trustees on these and other asset type issues (not mentioned in this article) can reduce the risk of compliance issues or simply lessen the level of annual audit angst from trustees and their accountants (and even the auditor).