The complexity of in-house assets

The SMSF in-house asset rules are nuanced and certainly not straightforward. ASF Audits head of education Shelley Banton examines the rules to which trustees must adhere in order to avoid compliance breaches of this nature.

The legislation surrounding in-house assets (IHA) within the SMSF landscape is complex. The core of the regulatory framework requires SMSF professionals to identify whether an asset is a related-party asset, as specified by section 10(1) of the Superannuation Industry (Supervision) (SIS) Act, determine whether it is an IHA, as per section 71 of the SIS Act and then ensure compliance with the SIS Act and SIS Regulations.

Many interpretations exist of how to apply the IHA breaches under SIS Act sections 82, 83 and 84.

The correct approach is crucial, especially since IHA breaches are rated as high risk by the ATO and represent 17 per cent of all auditor contravention reports (ACR) lodged with the ATO by SMSF auditors.

One of the reasons for the regulator’s intense scrutiny of IHAs is they may be hiding the illegal early release of benefits.

The meticulous process of identifying IHAs within SMSFs requires a comprehensive understanding of the relevant definitions and criteria outlined in the legislation.

Overview of in-house assets

Section 71 of the SIS Act does not allow a fund to invest in IHAs exceeding 5 per cent of total fund assets that include:

1. an asset of the fund that is a loan to a related party of the fund,

2. an investment in a related party of the fund, or

3. 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.

A fund can invest in any of these IHAs if the value of the IHA is 5 per cent or less of the total fund assets.

A common mistake is using net fund assets instead of total fund assets, resulting in an incorrect IHA percentage calculation.

Also crucial for assessing compliance and calculating a fund’s IHA ratio is understanding the assets excluded from being an IHA, such as:

a. a life insurance policy,

b. a deposit with an approved deposittaking institution,

c. business real property leased to a related party under a lease or lease arrangement,

d. an investment in a widely held trust, and

e. an investment in a related entity that meets the requirements of SIS regulation 13.22C.

Who is a related party?

Identifying related parties is the first step in determining whether an asset is an IHA:

• all members of the fund (as defined by the governing rules),

• standard employer sponsors (who contribute under an arrangement between the employer and trustee), and

• Part 8 associates of the members or standard employer sponsors (defined under SIS Act Part 8).

While identifying fund members and standard employer sponsors is relatively straightforward, recognising Part 8 associates introduces additional complexity.

A practical tip is to start from the SMSF member and progressively work outward towards the associated entity. It involves tracing members’ connections to various entities and assessing whether they meet the Part 8 associate criteria.

Attempting to work backwards may introduce unnecessary complexity and confusion into the identification process.

Demystifying how sections 70B, 70C and 70D of the SIS Act apply under Part 8 is also essential for accurately identifying related parties of fund members.

SIS Act section 70B

Section 70B of the SIS Act provides the answers to who is a Part 8 associate of fund members, including:

• relatives of each member and their spouses,

• all other members of the SMSF,

• all other trustees, both individual trustees or directors of the corporate trustee,

• a partner in partnership with each member,

• any spouse or child of those business partners,

• any company the member or their Part 8 associates control or influence, and

• any trust the member or their Part 8 associates control.

The broad scope of relationships captured under section 70B requires a thorough examination of family ties, business affiliations and, most importantly, companies and trusts controlled or influenced by the member or their Part 8 associate.

The ATO, in particular, is concerned about the control and influence a member or their Part 8 associate may exert over an entity.

Control of a company

SIS Act section 70E(1)(a) states a member of an SMSF will be considered to control a company if the entity is sufficiently influenced by the member and/or a Part 8 associate of that member.

The situation occurs where a majority of the company’s directors have become accustomed, obliged or might reasonably be expected to act under directions, instructions or wishes of the member and/or Part 8 associates of the member.

Identifying control requires thoroughly understanding the relevant facts, circumstances and practical testing.

One common scenario is a company with two directors, where one director exerts significant influence despite the appearance of board independence. Annual minutes or other company communications may be valuable in assessing control within such a company.

Control can also manifest when a member or their Part 8 associate holds a majority voting interest in the company, enabling them to cast or control the casting vote or possess more than 50 per cent of the maximum votes.

The company’s constitution serves as a key document in determining the extent of control, providing insights into voting rights and decision-making.

Control of a trust

Under section 70E(2) of the SIS Act, an entity controls a trust if:a group in relation to the entity is entitled to a fixed entitlement of more than 50 per cent of the capital or income of the trust if:

• the trustee of the trust, or a majority of the trustees of the trust, is accustomed to or under an obligation (whether formal or informal) or might reasonably be expected to act in accordance with the directions, instructions or wishes of a group in relation to the entity, and

• a group in relation to the entity is able to appoint or remove the trustee, or a majority of the trustees, of the trust.

The definition of a group related to an entity widens the Part 8 associate net because it encompasses an individual, a company, a partnership or a trust.

Underestimating the importance of a trust deed or the corporate trustee’s constitution can have dire consequences for an SMSF. These documents serve as critical sources of information regarding control structures, voting rights and trustee removal and appointment within the trust.

Once again, minutes and other documentation may also indicate one or more entities are acting as a group and controlling the trust.

Sections 70C and 70D

While these sections of the SIS Act also help identify a related party, they should be applied only after careful consideration.

Section 70C refers explicitly to a standard employer-sponsor and only applies to SMSFs with such arrangements.

Section 70D covers partnerships and is irrelevant for identifying a Part 8 associate of the member because the member is an individual, not a partnership.

Applying the IHA rules

The interaction between the IHA rules and SIS Act Part 8 underscores the legislation’s holistic approach to SMSF compliance.

While a fund may invest in IHAs within the prescribed limits, breaches of the 5 per cent threshold trigger specific reporting requirements in SIS Act sections 82, 83 and 84.

Understanding the nuances of the IHA breaches is essential to ensure SMSF compliance.

Section 82

Where the IHA level exceeds 5 per cent at the end of the income year, the fund triggers section 82 and the trustees must prepare a written plan by the end of the following income year that:

a. specifies the excess amount worked out using the formula,

b. sets out the steps to reduce the limit of the fund’s IHA ratio to 5 per cent or less during the following year of income, and

c. trustees must carry out.

Timing of trustee obligations

The timing of the trustee’s response to triggering SIS Act section 82 at the end of the financial year (year 0) plays a crucial role in determining whether a breach of that section exists.

The trustee must undertake action or prepare a plan and reduce the level of IHAs to 5 per cent or less by the end of the following year (year 1) of income.

There is no breach of section 82 in year 1 because it requires trustees to take corrective action in year 1.

Where the trustees fail to meet their obligations in year 1, they will breach section 82 in the subsequent year of income (year 2), with the SMSF auditor reporting the breach to the ATO in an ACR in year 2.

If the level of IHAs reduces to 5 per cent or less in year 1 because of changes to the market value of fund assets, the trustee is still required to meet their obligations under the act.

A change in market values in year 1 does not remove the requirement to rectify a breach triggered in year 0 in line with section 82.

Timing of auditor obligations

Upon signing the audit report in year 1, the auditor requests the written plan from the trustees and outlines their responsibilities under section 82 in the management letter.

However, if the trustees fail to provide a written plan or do not reduce the IHA level to 5 per cent or less by the end of year 1, the auditor must report the breach to the ATO in year 2.

If the year 0 audit is conducted in year 2 for any reason, such as late lodgement, the fund is deemed to have triggered section 82 in year 0 but did not meet the requirements of section 82 by year 1.

Under this scenario, the auditor has no choice but to report the breach to the ATO in year 2.

Section 83

Where the IHA level exceeds 5 per cent at any time during year 0, section 83 will apply as a reportable breach in that year because trustees must not acquire an IHA that exceeds 5 per cent of the market value ratio.

Unlike section 82, which focuses on breaches at a specific time, that is the end of the income year, section 83 addresses breaches that occur at any time during the income year.

For instance, when an asset exceeds the 5 per cent IHA level at any time during year 0 but is subsequently reduced to 5 per cent or less or disposed of before the end of year 0, the fund has still breached section 83.

Again, the SMSF auditor must report the breach to the ATO in an ACR.

Lease arrangements

While a loan or an investment in a related party can exceed the 5 per cent IHA level during an income year, there is confusion when the IHA is an asset subject to a lease or lease arrangement.

The problem is understanding whether it is the lease or the asset that is the IHA.

In line with SIS Act section 71, the definition says it is “an asset subject to a lease or lease arrangement”, meaning the asset is the IHA, not the lease.

During the year

When a related party uses the residential property during year 0, the asset is an IHA from when the related party first uses it until they vacate the property.

Assume an SMSF owns a residential property rented to a related party on 1 September and vacates it on 31 December.

The property is an IHA of the fund from 1 September until 31 December.

Where the value of the IHA asset ratio exceeded 5 per cent during that period, the fund breaches section 83 of the SIS Act and the SMSF auditor must report the breach to the ATO.

A section 83 breach will not trigger a section 82 breach because there is no IHA issue at the end of year 0, only during the year.

At year end

If the IHA exceeds the 5 per cent level at the end of year 0, the fund still breaches section 83 because it applies at any time of the year.

Essentially, the fund will trigger the requirements under section 82 (which is not reportable in that year of income), but will breach section 83, which is reportable to the ATO.

Section 84

SIS Act section 84 requires SMSF trustees to take all reasonable steps to comply with the IHA rules and apply to the fund any time during the year.

The overarching principle guiding the application of section 84 is whenever a section 83 breach exists, a section 84 breach is also reported to the ATO in an ACR. The mechanics of applying section 84 are the same as outlined in the section 83 section above.

Conclusion

Navigating the complexities of IHA regulations requires a nuanced understanding of the legislative framework and meticulous attention to detail.

As SMSF professionals continue to navigate the evolving regulatory landscape surrounding IHAs, it is imperative to stay informed about legislative updates, ATO guidelines and best practices in assessing compliance.