3 simple rules regarding related party transactions to help keep funds compliant

SMSF trustees can be at risk of being ‘one-eyed’ when it comes to related party investments. They must be careful to ensure that investments are undertaken to maximise retirement savings and not using fund assets simply as a source of investment revenue for their personal businesses or for personal use.

An SMSF is a separate legal entity and trustees have an obligation to ensure that their dealings, including those with related parties, are conducted in the members’ best interests. Failure to do so is a failure to meet their fiduciary obligations as a trustee and can cause the fund to be scrutinised by the ATO, potentially incurring penalties.

Here are 3 simple rules to help keep your funds compliant.

Acquisition of assets from related parties

It’s essential that all dealings between related parties are done in conjunction with the fund’s investment strategy and trust deed. Remember, too, that the only assets a fund can intentionally acquire from a related party are money or cash, listed shares, business real property and certain in-house assets.

While the definition of cash and listed shares are easy to define, there are 2 necessary conditions that business real property must satisfy prior to acquisition:

1. The SMSF or the other entity must hold an eligible interest in real property
2. The underlying land must meet the business use test, e. the real property has to be used wholly and exclusively in one or more businesses carried on by an entity

All acquisitions must be made at market value with business real property being subject to a market valuation at least three months before the acquisition. The ATO recommends the use of a qualified independent valuer where the value of the asset represents a significant proportion of the fund’s value.

Once the asset is in the fund SMSF trustees can provide a valuation of the property in future years, but the hurdles are difficult to clear. They must be able to demonstrate that the valuation has been arrived at using a ‘fair and reasonable’ process, which should include an explanation to a third party (i.e. the auditor).

Related party income

When there’s a related party transaction either in the fund or in a related unit trust, the auditor will look at the investment in a different light. They will start by questioning whether the rent is being paid at market value and whether the terms of the lease are conducted at arms-length.

It’s best that an independent rental assessment is provided to confirm the rent is at market rates at the time of submitting the audit to avoid delays.

Any identified shortfall in rent may be a breach of s 109 SIS and reportable to the ATO. The timing of rent payments and all lease-related payments, such expenses, are also checked to ensure they’re in accordance with the terms of the lease and on an arms-length basis.

The NALI effect

There can be significant tax implications for SMSFs from income-producing related party assets such as business real property, companies and unit trusts.

One of the most common examples is where the fund holds property, and the lessee is a related party. When rent is being paid at higher than market rates, a tax issue is generated as the investment is not being maintained on an arm’s length basis.

As a result, all of the income that the fund receives from that asset may be deemed as non-arm’s length income (NALI).

NALI is taxed at the highest marginal rate and applies regardless of whether the fund is in pension mode. Most importantly, it includes all of the income generated from the asset since the day of acquisition.

Conclusion

When related parties become part of the SMSF investment landscape, there are 3 simple rules that can help keep funds compliant.

The first one is to provide annual market valuation documentation demonstrating that all transactions are booked at current market value to comply with R8.02B SIS. The second is to ensure that all related party income is being paid at market rates and, finally, ensure transactions are undertaken on an arms-length basis to avoid NALI.

Of course, the legislative complexities surrounding related parties mean more onerous obligations and responsibilities for SMSF trustees and their advisers. Keeping on top of it all is the key.

If you have any questions, feel free to ask them in the comment section. We will be happy to answer all your queries.