What to do with in-house assets

There are strict rules applying to in-house assets that all SMSF trustees must consider. Mark Ellem explains how an in-house asset breach occurs and the courses of action that must be taken in these circumstances.

Where an SMSF has an asset that is an in-house asset, that alone is not a breach of the superannuation rules. The breach occurs where the rules applying to an in-house asset are not followed. Consequently, once it’s determined an SMSF has an in-house asset, the relevant rules must be followed.

Non-compliance with the in-house asset rules can lead to the imposition of 60 penalty points under the SMSF administration penalty regime and, using the current value of a penalty point, that would be a fine of $13,320 per trustee. Based on auditor contravention reports (ACR) lodged during the period 1 July 2004 to 30 June 2020, breaches of the in-house asset rules were the highest reported breach by value and second highest by percentage of total reported infractions. So, understanding when an asset of an SMSF is an in-house asset and/or subsequently following the prescribed rules appears to be a continuing challenge.

Defining an in-house asset

Sub-section 71(1) of the Superannuation Industry (Supervision) (SIS) Act defines an in-house asset of a superannuation fund as one that is any of the following:

1. a loan to, or an investment in, a related party of the superannuation fund, or

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

3. an asset of the superannuation fund that is subject to a lease or lease arrangement between the superannuation fund trustee(s) and a related party.

The ATO has outlined in SMSF Ruling 2009/4 its view of the meaning of a number of in-house asset terms as they apply to the definition of an in-house asset.

While an asset of an SMSF may prima facie be an in-house asset, it may be excluded from the in-house asset rules. Sub-paragraphs 71(1) (a) through to (j) of the SIS Act provide a list of assets that are specially excluded from being treated as an in-house asset.

There are also anti-avoidance provisions within the in-house asset rules that have the purpose of capturing any schemes or arrangements entered into for the purpose of circumventing the in-house asset rules. Subsection 71(4) of the SIS Act also effectively gives the ATO commissioner the power to deem an asset as an in-house asset. The deeming powers of the tax commissioner to treat an asset as an in-house asset was referenced in the ATO’s decision impact statement on the Aussiegolfa case. While the court decided the power was not required in that particular case, the ATO stated: “The ATO will continue to consider issuing a determination under subsection 71(4) of the SIS Act as appropriate in circumstances where the trustee of a SMSF enters into an arrangement to acquire an asset that would otherwise be an in-house asset under section 71 of the SIS Act if directly held by the SMSF.”

The commissioner can also make a determination not to treat an asset of a superannuation fund as an in-house asset. The commissioner has outlined the ATO’s approach to making such a determination in Practice Statement Law Administration 2009/8.

Breach of the in-house asset rules

Once it is determined an SMSF has an inhouse asset, as stated earlier, this is not in itself a breach. However, sub-section 84(1) of the SIS Act requires the trustee(s) to take all reasonable steps to ensure they comply with the in-house asset rules. These can be summarised as follows:

Rule 1: The year-end in-house asset market value ratio test.

If, at the end of the income year, the market value ratio of in-house asset of an SMSF exceeds 5 per cent of the total fund’s assets, the trustees must prepare a written plan to reduce this ratio to 5 per cent or below. This plan must be prepared before the end of the next following income year and each trustee must ensure the steps in the plan are carried out as stipulated in section 82 of the SIS Act. For example, if an SMSF exceeds the 5 per cent in-house asset market value ratio as at 30 June 2022, a plan must be prepared and implemented on or before 30 June 2023.

Rule 2: In-house asset market value ratio already exceeds 5 per cent.

Where the market value ratio of an SMSF’s existing in-house assets already exceeds 5 per cent, under sub-section 83(2) of the SIS Act, the fund is prohibited from acquiring any further in-house assets.

Rule 3: In-house asset market value ratio does not exceed 5 per cent.

Where the market value ratio of an SMSF’s existing in-house assets does not exceed 5 per cent, the fund is prohibited from acquiring any further in-house assets where it would result in in the fund’s in-house asset market value ratio exceeding 5 per cent as stated in sub-section 83(3) of the SIS Act.

A breach of SIS Act sub-section 84(1) will occur where either of the above three rules apply but are not followed.

Calculating the market value ratio

For the purpose of determining a fund’s market value ratio of its in-house assets, either at the time an in-house asset is being acquired or for the year-end in-house asset rule, the formula in sub-section 75(1) of the SIS Act is applied as follows:

Number of whole dollars in value of in-house assets

divided by

Number of whole dollars in value of all fund assets

For example, an SMSF with a limited recourse borrowing arrangement (LRBA) has gross assets of $2 million, but after allowing for the loan under the LRBA of $600,000, has net assets of $1.4 million. Where the SMSF also has an in-house asset, the market value ratio will be based on the fund’s gross assets of $2 million and not its net assets of $1.4 million.

When calculating the market value ratio using the formula in Table 1, any fund liabilities should be ignored.

Lease or lease arrangements

As noted, an in-house asset includes an asset subject to a lease or a lease arrangement between an SMSF and a related party. The in-house asset exclusions permit an SMSF to lease business real property to a related party. However, consider the scenario where the property does not satisfy the definition of ‘business real property’, for example, a residential property and consequently the lease of the fund’s property is an in-house asset of the SMSF.

In these situations the in-house asset rules must be applied. That is:

• the year-end in-house asset market value ratio test (rule 1), and

• the 5 per cent tests for acquiring a new in-house asset (rules 2 and 3).

For the purpose of applying the rules, it’s important to determine the value of the in-house asset. In relation to an asset where a lease or lease arrangement is involved, the value of the in-house asset is the value of the asset subject to the lease, that is, it is the value of the residential property and not the value of the rental income during the period it was leased to the related party. It would generally be expected the value of a property held would be more than 5 per cent of the value of total fund assets.

Does simply ceasing the lease to the related party rectify the fund’s in-house asset issue? This will depend on which of the inhouse asset rules apply.

• Where the lease or lease arrangement to the related party was in place on 30 June, the year-end in-house asset rule applies. This requires the trustee to put in place a written plan to dispose of the excess in-house asset amount by the following 30 June. Cessation of the lease to the related party does not satisfy the requirement to dispose of the excess in-house asset amount. As the in-house asset is the item subject to the lease or lease arrangement with the related party, that asset is the one requiring disposal. However, the ATO has provided previous guidance in National Tax Liaison Group Super Technical minutes from June 2012 that while it considers the cessation of the lease not satisfying the requirement to dispose of the excess inhouse asset amount, where it was a one-off breach the regulator is unlikely to make the fund non-complying. It should be noted, however, these comments from the ATO were made prior to the introduction of the SMSF administration penalty regime. The fund would have also likely not complied with either sub-section 83(2) or 83(3) of the SIS Act.

• Where the lease or lease arrangement ceases prior to 30 June, there is no longer a lease arrangement between the fund and the related party. Therefore, there is no longer an in-house asset, the year-end in-house asset does not apply and there is no requirement for the written plan to dispose of the excess in-house asset amount. However, it is likely the fund has not complied with either sub-section 83(2) or 83(3) of the SIS Act as it acquired an in-house asset (commencement of the lease to the related party) and the value of the property is used for the purpose of the 5 per cent market value ratio limit, taking it above the 5 per cent threshold. Consequently, the fund has also breached section 84 of the SIS Act as the in-house asset rules have not been complied with.

Of course, the ATO may take further action if the lease of the residential property for short periods of time continues in subsequent income years and it can be seen to deliberately cease prior to each 30 June so as not to trigger the year-end in-house asset market value test in SIS Act section 82. That is, it would be prudent to ensure it doesn’t happen again.

Interaction of the in-house asset rules with other rules

In addition to compliance with the in-house asset rules, consideration should also be given to the application of other provisions of the SIS Act and SIS Regulations and the Income Tax Assessment Act and Regulations, including, but not limited to:

Investment strategy: while the fund’s in-house asset market value ratio may not exceed 5 per cent, does the investment fit within the fund’s investment strategy?

Sole purpose test: again, while the fund’s in-house asset market value ratio may not exceed 5 per cent, does the fund have relevant evidence to show the sole purpose of making the investment was the provision of retirement benefits for members?

Arm’s-length dealings: any investment or loan or fund asset under a lease or lease arrangement must be on arm’s-length terms.

Lending to fund members: a trustee must not lend money to a fund member or their relative or provide financial assistance using the resources of the fund, again, to a fund member or their relative.

Non-arm’s-length income provisions: where the terms of a related-party transaction are not at arm’s length and result in the SMSF deriving more income or incurring less expenditure than what would have been the case had the SMSF and the other party been dealing on an arm’s-length basis, the resulting income could be treated as non-arm’s-length income. This will lead to tax penalties imposed on the SMSF.