The requirement to be dealing at ‘arms length’ with your SMSF is an important part of superannuation law to ensure prevention of transactions that may allow fund assets to be used as a source of concessionally taxed benefits to members in pre-retirement years, or to advantage non-members.
Section 109 of the Superannuation Industry (Supervision) Act (SIS Act) requires that all investment transactions of a SMSF must be made and maintained on an arm’s length basis.
It is important to note that transactions need not necessarily be at arm’s length (i.e. they may be between related or associated parties) but investment transactions must be on an arm’s length (commercial) basis.
When making a fund investment, it must be entered into and maintained on commercial terms, or on terms that are no more favourable to the other party than would reasonably be expected if the dealing was at arm’s length in the same circumstances. For example, the purchase price of an investment such as business real property (where in-specie transferred) should be at market value. In addition, the agreed or expected return from that investment should be at not less than a true market rate. It is therefore important where such an asset is being transferred into a SMSF, that an independent valuation is obtained to determine the asset value in the current market.
Note: Super Circular SC2003/1 provides guidance for SMSFs relating to methodology for the appropriate determination of market values for particular fund investments, including property. The preliminary report of Phase Three of the Cooper Review is to recommend independent sworn valuations to be obtained for any transfer of Business Real Property (BRP) into a SMSF.
Certain situations may lead a SMSF to have income assessed at a 45% tax rate where a SMSF is not acting on an arm’s length basis. This is referred to as “non-arm’s length” income (or special income).
It is the responsibility of the trustees of the SMSF to enforce their ongoing rights against a related party in the same manner as they would enforce their rights against any other party. For example, if the tenant (your business) defaults on a loan and appropriate remedial action is not taken then the arm’s length requirement would be breached.
In addition to the arm’s length requirements, any investment undertaken must be part of a properly formulated and implemented investment strategy for the entity as required under section superannuation law.
Some examples of non-arm’s length transactions include:
- Paying ‘below market’ or ‘above market’ rent for a commercial property (BRP) your business is renting from your SMSF;
- above market rent could be taxed at 45% as non-arms length income
- Transferring shares (e.g. BHP) into your SMSF at less than market value;
- this can also potentially affect contribution caps and excess contributions tax determinations
- Where a distribution from a related trust is not paid (where it is owing)
- this was particularly common with unpaid present entitlements in related unit trust arrangements
- SMSF Instalment Warrant loan arrangements with a lower interest rate than can be obtained in a normal lending environment.
- relevant for BYO banker arrangements (related party loans)
- Artwork hanging in the member’s own home with no payment for the use of this asset
- amongst other compliance issues in doing this!!
It can appear quite easy to ‘abuse’ the system when it comes to related party transactions, however section 109 of the SIS Act is enshrined within the SMSF independent auditor process to ensure that Trustees operate on commercial terms. Any breach in respect to arms-length dealings are required to be reported to the Regulator (ATO) using the Auditor Contravention Report (ACR).
SMSFs have plenty of advantages, but you need to ensure that you operate them on a level playing field.