The ATO’s website (at QC 61775) on 27 March 2020 was updated to state under the heading “Temporarily reducing rent”:

Question: My SMSF owns real property and wants to give my tenant — who is a related party — a reduction in rent because of the financial impacts of COVID-19. Charging a related party a price that is less than market value is usually a contravention. Given the impacts of COVID-19, will the ATO take action if I do this?

Answer: Some landlords are giving their tenants a reduction in or waiver of rent because of the financial impacts of COVID-19 and we understand that you may wish to do so as well. Our compliance approach for the 2019–20 and 2020–21 financial years is that we will not take action where an SMSF gives a tenant — who is also a related party — a temporary rent reduction during this period.

Broadly, the ATO will not actively seek out cases where an SMSF gives a related-party tenant a temporary rent reduction during the remainder of FY2020 or FY2021. However, the usual position for such practical approaches previously issued by the ATO is that if the ATO does come across contraventions from other sources — e.g. via its usual data detections, reviews or auditor contravention reports (ACR) — the ATO will usually apply the legislation in the normal manner. While the ATO should be congratulated on the practical approach reflected above, SMSF trustees should not rely on this non-binding guidance, given the substantial downside consequences, especially given these situations may be legitimately resolved with appropriate action as outlined below.

We do understand, however, that some SMSF trustees and/or businesses may not have the time or resources to obtain proper advice with regard to related-party tenants, and may choose to simply rely on the ATO practical approach at their own risk. However, given the consequences, landlords should take every measure available to them to place themselves in as sound position as possible to minimise future risk.

Furthermore, the ATO website does not provide any express relief for an SMSF that owns property via an interposed unit trust, such as a non-geared unit trust (NGUT). Once a contravention of one of the criteria relating to a NGUT is triggered under reg 13.22D of SISR, the trust is “forever” tainted and the SMSF must dispose of its units in that unit trust to comply with the SISR. In particular, if the lease is not legally enforceable or if rent owing by a related-party tenant accrues and constitutes a loan under the lease, the unit trust will cease to comply with the criteria in Div 13.3A of SISR.

SMSFs with LRBAs –– further implications

If an SMSF has borrowed money under a limited recourse borrowing arrangement (LRBA) to finance the acquisition of a property (whether residential or business real property), a range of other implications may arise including:

• Similar issues to the potential SISA contraventions raised above also may apply if a related-party lender does not act at arm’s length in relation to collecting all money owing under the LRBA as an arm’s-length lender would apply to a third-party lender. However, a related-party lender would typically not consider taking any such action against the SMSF trustee given they are related. Again, appropriate arm’s-length evidence must be gathered and accounting and legal advice obtained to position against the significant penalties that may otherwise be applied.
• If there is a related-party lender, unless the “safe harbour” terms and conditions of the borrowing are consistent with the ATO’s criteria in PCG 2016/5, that are continuously complied with (e.g. regular monthly principal and interest repayments), the ATO has advised they will typically consider applying non-arm’s length income (NALI). The following is a helpful extract from this PCG:

The trustees will need to be able to otherwise demonstrate that the arrangement was entered into and maintained on terms consistent with an arm’s-length dealing. One example of how a trustee may demonstrate this is by maintaining evidence that shows their particular arrangement is established and maintained on terms that replicate the terms of a commercial loan that is available in the same circumstances. 

Indeed, if the tenant reduces or stops paying rent, the SMSF’s ability to make repayments under the LRBA can easily fall into arrears and into default (with the default interest rate — typically at least 2 per cent higher than normal) under the loan agreement, giving rise to a range of further ramifications. If the related-party lender provides any relief to the SMSF trustee that is not benchmarked to arm’s-length terms (that can be justified in these difficult times), based on recent ATO materials (including LCR 2019/D3), the ATO position is that NALI may then apply to any net income and net capital gain, if any, derived from that property for the entire future period of ownership.

We would be pleased to advise and assist to minimise the potential future risk of NALI being applied.

Possible consequences of contravening SISA

Despite the ATO’s non-binding practical approach outlined above, a range of other contraventions may also occur (or may occur in the near future) in these difficult and stressful economic times if, for example, money is withdrawn without a valid condition of release or existing SMSF assets are used as security for a borrowing by a related party. When added to non-compliance by an SMSF trustee or “connected” unit trust renting property to a related-party tenant (e.g. a NGUT), then SMSF trustees may be widely exposed to a range of penalties and costly disputation.

There are a range of potential penalties that the ATO may apply unless these matters are appropriately and properly managed, including:

• In extreme cases, the fund could be rendered non-complying, with 45 per cent tax imposed on the value of its opening account balance in the year it is rendered non-complying.
• Contravention of a civil penalty such as s 62, s 65, pt 8 and s 109 can result in a monetary penalty of a maximum amount of $504,000 (i.e. 2,400 penalty units x $210).
• An administrative penalty, typically of $12,600 per contravention for s 65 and pt 8, and the ATO’s stated policy is to “automatically” impose an administrative penalty for each and every occasion. An SMSF trustee can seek remission of any penalty; the success of which depends on whether the ATO considers any remission is appropriate in the circumstances.

This type of situation highlights the need for making sure SMSF trustees act in compliance with the law and do not make rash or hasty decisions that they may later regret, especially if the actions were designed to assist a related party without any evidence documenting that the actions were consistent with an arm’s-length dealing and/or without following and taking the appropriate steps to implement a lease variation.

This is where a written opinion from an SMSF lawyer, which is subject to legal professional privilege, outlining the law in view of the particular facts is a prudent first step to take in this journey. A written opinion that is supported with the right evidence and that is implemented correctly can save on costs that may otherwise arise from needing to respond to the likely auditor or ATO queries and any ACR that may be lodged, which may give rise to unnecessary inquiries by the ATO.

Sole purpose SMSF corporate trustee

If an SMSF trustee grants a concession to a related-party tenant, the administrative penalties on their own can, in these types of circumstances, give rise to hundreds of thousands of dollars, as the ATO might argue that each monthly payment of rent not made is subject to an additional penalty.

If the SMSF has, say, two individual trustees, then the administrative penalties will be double the amount that would be imposed on two directors of an SMSF corporate trustee, as each individual trustee is subject to the same amount of administrative penalties. For example, if the SMSF has two members who are individual trustees, then the typical $12,600 for a single administrative penalty is double, i.e. $25,200. If the SMSF had a corporate trustee with the two members as directors of the corporate trustee, the administrative penalty is $12,600.

Naturally, we strongly recommend that each SMSF has a sole purpose SMSF corporate trustee to minimise legal risk given the current economic conditions. Many SMSFs still have individual trustees who remain personally liable for a fund’s liabilities, and the administrative penalty system is a big incentive to move to a corporate trustee in these testing times.

Our recommendation that an SMSF have a sole purpose corporate trustee is also very important in these difficult economic times, given that many “trading” companies that also double up as an SMSF trustee may be facing insolvency with the appointment of an administrator, liquidator, receiver or some other form of external management which could soon “take over” control of that company and make the management the SMSF assets very difficult until that company’s external controller is convinced that the SMSF assets are not capable of being applied towards the creditors. This “fight” alone may prove difficult and costly.

Conclusions

Naturally, the above matters should be taken very seriously and it is important that SMSF trustees obtain sound expert accounting, financial, valuation, legal and other advice to prevent hasty actions that are designed to preserve a related-party tenant’s cash flow to assist their business from backfiring.

Daniel Butler, director, and Bryce Figot, special counsel, DBA Lawyers

To read Part 1 of this article, click here.