Legislation surrounding these related unit trusts i.e. trusts exempt from in-house assets under regulations 13.22B or 13.22C of Superannuation Industry (Supervision) Regulations 1994 (SISR). is involved and complicated. The result is that an SMSF trustee with a complying fund can run afoul of the rules in a short time and quickly find themselves on the non-complying side of the fence.

That’s why it is critical practitioners ask the right questions, identify the important issues and stop them multiplying in the future.

In-house assets

One of the most common problems in practice relates to property held in a related unit trust. When the property is rented out to a related party, any downturn in business sees the related party looking for ways to protect their cash flow.

The decision to forgo paying rent might seem like a simple solution at the time to avoid dire financial straits. But the consequences of such a decision can have disastrous flow-on effects for the SMSF.

The first warning flag for an SMSF auditor is finding receivables on the balance sheet of a related unit trust. Where such an amount represents unpaid rent, it’s not a commercially acceptable practice to accept payment of rent in arrears for any property, other than rural/farming property.

Tolerating this situation may happen when the fund or the related unit trust is dealing with an unrelated tenant who may be in some temporary financial distress.

However, when the fund or the unit trust repeatedly allows a related party tenant to go into significant arrears, this amounts to financial assistance to that related party and prevents such an arrangement from being treated as an arm’s length arrangement.

Arm’s length dealing requirement is of utmost importance in this instance because the fund’s investment in the related unit trust is exempt from being an in-house asset by way of regulation 13.22B or 13.22C of SISR.

Once the unit trust is exempt under these provisions, it is then also subject to provisions of regulation 13.22D of SISR, including a requirement that the unit trust conducts all transactions on arm’s length terms (reg. 13.22D (1)(l) of SISR).

Where there is a breach of this requirement (or any other requirement in reg. 13.22D of SISR), regulations 13.22B and 13.22C of SISR cease to apply to the fund’s investment in this unit trust and the whole of this investment becomes an in-house asset.

Once this happens, the investment can never again be exempt from in-house asset rules under these provisions.

When the rental arrears become greater than $30,000 or 5 per cent of fund total assets, the SMSF auditor is required to report a contravention of the in-house asset regulations to the ATO, as per the Auditor Contravention Report guidelines.

Reaching the specified threshold means that SMSF auditors have no discretion and are obliged to report the matter. Any subsequent payments of rent will be commented upon and included in the contravention report and the management letter.

Arm’s length dealings

One of the inevitable consequences of the rental arrears inside the unit trust is the trust’s inability to pay distributions to the fund in a timely fashion, thereby resulting in another potential breach of superannuation law.

The primary concern then becomes the fund’s current account with the unit trust remaining unpaid. Distributions from a related unit trust that remain outstanding for over 12 months represents a breach of arm’s length requirements of section 109 of Superannuation Industry (Supervision) Act 1993.

If such an arrangement were at arm’s length, the unpaid party would formally request payment of the outstanding trust distributions.

In most cases, no such evidence exists and there is no accompanying payment of interest or any compensation given for non-payment. This arrangement would imply that a consensual agreement exists between the related parties, which then meets the extended definition of a ‘loan’.

Once again, where the amounts are more than $30,000, or 5 per cent of fund total assets, SMSF auditors are required to report this as a contravention to the ATO.

Sole purpose test

Determining whether a transaction meets the sole purpose test under section 62 of Superannuation Industry (Supervision) Act 1993 involves looking at the overall conduct of the fund.

All fund assets must be used for the specified purpose of providing retirement or death benefits in relation to the members to meet the test. 

The commissioner has said that considering one factor alone will not be decisive in determining whether the fund breaches s62 of SISA.

However, when the related unit trust is a material asset with unpaid trust distributions upon which the fund receives no market interest, this might indicate that the fund’s assets are being used as a low-cost source of capital for the related trust.

Under these circumstances, the fund would be in contravention of the sole purpose test as fund assets are not being maintained for the requisite purposes as outlined in s62 of SISA.

As it’s not easy to apply the monetary thresholds of the Auditor Contravention Report guidelines to breaches of the sole purpose test, an SMSF auditor will have to use their professional judgment to determine whether to report the contravention to the ATO.

The auditor will consider the significance of the breach in light of the exempt status of the fund’s investment in the unit trust.

Of course, the behavioural test still applies, where any contravention not rectified from the previous year’s audit is mandatorily reported to the ATO.

The solution

There are far-reaching implications for SMSF trustees and their advisers for funds with non-geared related unit trust issues.

Once there’s a breach of any requirement of regulation 13.22D, no matter how small, the trust is no longer exempt from being an in-house asset of the fund.

Once this occurs, the only way to rectify the breach is to liquidate the assets and wind up the trust.

Regardless of whether all outstanding rent and distributions are eventually repaid, an SMSF auditor is unable to give the fund back their green tick of approval.

The best course of action, and the only chance of salvation, is to work collaboratively with the ATO (and your SMSF auditor) through voluntary disclosure. SMSF trustees have the opportunity for remediation and rectification, which hopefully gets the fund back to a complying status.

The risk

Choosing an SMSF auditor who understands the importance of keeping a related unit trust on the straight and narrow is mission critical to fund compliance.

The reality is that any SMSF auditor who charges a minimal fee cannot (due to budgeting constraints) and will not spend the time required to examine complex investments, such as related unit trusts thoroughly.

This means they are very likely to miss a major compliance issue. SMSF trustees will face hefty penalties and will potentially have the fund taxed at the top marginal rate when this is picked up during a random ATO audit.

When one considers what’s at stake, is the audit cost saving worth the risk?

Shelley Banton, director, Super Auditors