Generally, as an SMSF trustee you are free to invest in any assets that will contribute to your retirement savings. Provided that at the time of the investment, you have a genuine and bona fide belief that a particular investment is appropriate for your SMSF and it is accommodated within your investment strategy, then you are on a safe footing. Even where that investment may turn out to be a poor one, resulting in the SMSF losing money, your decision will still be considered to be appropriate by the Regulator, the ATO.
This “retirement purpose”, also known as the “sole purpose test”, must be evident in your decision-making process when choosing investments.
Firstly, we will look at the sole purpose test and see how the decisions and actions of you as an SMSF trustee are benchmarked against this critical test by the ATO.
The sole purpose test
The ‘sole purpose test’ requires that all your SMSF investments are made for the sole purpose of providing benefits for members on their retirement or for their dependants if a member dies. Other benefits, such as total and permanent disability benefits, benefits for temporary incapacity or income protection can also be provided in appropriate circumstances.
The ATO will look to trustee investment decisions to see if their decisions are consistent with this purpose or whether there are other influences at work. For example, they may ask whether there are other benefits in making a particular investment which will immediately benefit trustees or related parties involved with that particular investment. They may query the retention of an investment with historically poor or non-existent returns to the SMSF, especially where that investment also represents a significant percentage of the SMSF assets. They may well infer a non-retirement purpose of benefit in such an investment and the trustees decision to retain that investment.
So, think carefully about the investments you make, and be clear as to your reasons for making that particular investment over others available to you.
A retirement purpose is just the beginning
In addition to the retirement purpose that should inform your investment decisions, there are also a series of rules which restrict SMSF trustees’ investment choices when dealing with related parties. These particular rules do not prohibit particular investments per se, but whom trustees can deal with in relation to those investments. This includes not only whom they can acquire assets from but also who can use those SMSF assets, even if a market rate is paid for that use.
Prohibition of SMSF trustees from acquiring assets from related parties
The general rule is that SMSF trustees cannot acquire any assets from a member or other related party. This includes other SMSF members, relatives of the members or entities such as companies or family trusts controlled by any of these people. Anyone in partnership with any of these, as well as the spouses and children of these partners are also affected by this rule.
It is worth noting that this rule applies only to the SMSF trustees acquiring assets from these individuals or entities. It does not extend to these individuals or entities acquiring assets from the SMSF. So, for example, it is acceptable for a lump sum benefit to be paid to a member by way of transfer of an SMSF asset to the member.
There are, however, limited and very important exceptions to this rule including:
• The acquisition of business real property (e.g. a warehouse from which a member’s business is run)
• shares in companies listed on any stock exchange
• units in widely held unit trusts such as publicly available managed funds, and
• investments in a related entity such as a private company controlled by a member, where the value of the SMSF investment doesn’t exceed 5% of the total market value of the SMSF assets, for example.
The ‘in-house asset’ rules
An “in-house asset” is a defined term meaning:
• a loan to or investment in a related party, such as a member’s private company
• an investment in a related trust, and
• a lease of SMSF assets to a related party.
The legislation limits the total amount of in-house assets to 5% of the market value of the SMSF. Such investments are considered to potentially compromise the retirement purpose of the SMSF and so are restricted in terms of the percentage of total assets of the SMSF.
In-house asset exceptions
Just as with the prohibition of acquisition of assets by SMSF trustees from related parties, there are some important exceptions to the basic rule limiting such investments.
(a) Business real property: The most common one is business real property that is owned by an SMSF and is rented to a member, a related party or a business owned and controlled by one of these individuals.
(b) Owning assets as tenants-in-common: It is not widely known that it is possible to own an asset as tenants-in-common with your SMSF. Use of the asset may still be subject to restrictions under other requirements however.
(c) Units in widely held unit trusts: These are typically publicly offered unit trusts owned for investment purposes by the SMSF. Closely held private unit trusts do not fall within this exemption.
Common assets subject to in-house asset restrictions
Assets other than business real property, owned by the SMSF and subject to lease arrangements with the member or other related parties are caught by the in-house asset restrictions.
The most significant asset caught by the in-house asset rules is residential property owned by the SMSF and leased to members or other related parties, such as children of members, as an example. Another common example is a holiday rental property owned by the SMSF. Where residential property is leased to a related party, even for a single day, the whole market value of the property counts as part of the 5% market value test for a particular year.
Examples of other assets caught up in this rule are plant and equipment used in a member’s business. For assets such as motor vehicles, artwork and similar “collectible” investments, see the later comments on collectibles and other personal use assets.
Breaching the in-house asset rules
As explained above, the total value of all these assets subject to lease arrangements with a member or other related party cannot represent more than 5% of the market value of the SMSF. You must monitor the percentage of in-house assets on an ongoing basis. Typically, this percentage is tested both at the time of acquisition of the asset as well as at each 30 June. If the percentage exceeds 5%, you need to reduce the level of in-house assets below 5%. One option would be selling some or all of the in-house assets.
The arm’s length rules
All investments must be made on an arm’s length basis and reflect the market value for the assets regardless of who buys or sells the assets.
Special rules also apply for tax purposes to non-arm’s length investing by an SMSF. Broadly, where an investment involves an inflated and non-commercial return to the SMSF due to a non-arm’s length arrangement being entered into by the SMSF and another party, the income from that non-arm’s length investment is taxed in the SMSF at 45% rather than at the concessional rate of 15%. Dividends from private company shares and certain other non-arm’s length investments are similarly taxed in certain circumstances.
The restrictions on providing financial assistance to related parties
An SMSF cannot provide either a loan or financial assistance to a member or relative of a member.
In particular, financial assistance is defined broadly and includes:
• gifting an SMSF asset
• selling an SMSF asset at less than market value
• the SMSF purchasing an asset for a higher amount than market value
• forgiving a debt owed to the SMSF
• the SMSF satisfying a financial obligation on behalf of a related party, and
• allowing SMSF assets to be used as security for the benefit of a related party.
The financial assistance can be direct to the individual, or indirect via a company or family trust.
The borrowing rules
An SMSF is only allowed to borrow money in limited circumstances, including to:
• make a legally required payment to a beneficiary or to pay the superannuation surcharge for a member, where the borrowing is for no more than 90 days and it doesn’t exceed 10% of the fund’s value
• cover the settlement of a transaction to acquire certain assets (such as shares and units in a unit trust) where the borrowing wasn’t anticipated and the loan is for no more than 7 days and it doesn’t exceed 10% of the fund’s value, and
• acquire certain assets by using a ‘limited recourse borrowing arrangement’.
Limited recourse borrowing arrangements
This is a structured borrowing arrangement which allows trustees of an SMSF to borrow to purchase certain assets. The rules are complex and specialist advice is needed if you are considering using this arrangement to purchase an asset. Most commonly, SMSF trustees use limited recourse borrowing arrangements to purchase real property, but it is also possible to purchase parcels of the same listed share or unlisted managed funds, for example.
The restrictions on using superannuation assets as security
Except when using a limited recourse borrowing arrangement, SMSF assets cannot be used as security for any loan arrangement. This means a charge cannot be placed over any of the SMSF assets by the trustees, even where the loan is being undertaken by someone other than the trustees.
The specific requirements for collectables and personal use assets
There are specific rules that apply to collectables and personal use assets, such as:
• artwork, jewellery and antiques
• coins, medallions and postage stamps
• cars and boats, and
• membership to sporting and social clubs.
Collectables and personal use assets acquired from 1 July 2011 must not be used by or leased to a related party or stored in a private residence of a related party. Also, the assets must be insured in the SMSF’s name. This restriction was extended to all collectibles whenever acquired from 1 July 2016.
In other words, use by way of lease of these assets does not fall under the general rules relating to in-house assets discussed above. Their use by members or related parties for any purpose is strictly prohibited.
As can be seen from the above discussion, the special rules around SMSF investments can be complex and sometimes confusing. It is important to be aware that while you are generally free to make your own investment decisions, these related party restrictions on how you interact with members and related parties of your SMSF can impact on whether your SMSF is being properly undertaken for retirement purposes or not – this is a very real issue and one which cannot be ignored.
We strongly advise that you use a qualified and specialised advisor to assist you, especially if there is some concern around whether a particular transaction is acceptable.
Disclaimer: The information contained in this document is provided for educational purposes only, is general in nature and is prepared without taking into account particular objective, financial circumstances, legal and tax issues and needs. The information provided in this article is not a substitute for legal, tax and financial product advice. Before making any decision based on this information, you should assess its relevance to your individual circumstances. While SMSF Association believes that the information provided in this article is accurate, no warranty is given as to its accuracy and persons who rely on this information do so at their own risk. The information provided in this bulletin is not considered financial product advice for the purposes of the Corporations Act 2001.