Commercial properties’ national vacancy rate has hit 11.75 per cent due to entire offices working from home, and further increases may be on the way.

Rental lease agreements

With flexible working arrangements becoming commonplace, the ability to command pre-COVID rents has been significantly affected. Many landlords are currently offering lease agreements with several incentives to lure tenants back into the market.

The problem for related-party tenants is that the specific incentive terms are not always publicly available as negotiations occur behind closed doors.

While there may be anecdotal evidence to support the rapidly changing nature of commercial lease agreements, SMSF auditors may not consider this to be sufficient appropriate audit evidence at audit.

Market value

Regulation 8.02B of the SIS Regulations requires that all assets must be valued at their market value, which is one of the compliance areas traditionally put under the ATO microscope. 

One of the issues SMSF trustees face from the impact of COVID-19 is uncertain SMSF asset values, including rent paid by related parties for property owned by the fund and related entities. 

ATO viewpoint

The ATO has recently updated its valuation guide concerning property on its website. SMSF trustees are required to provide objective and supportable evidence to demonstrate compliance with r8.02B.

Remember, too, that it is the trustee’s responsibility to provide documents supporting market valuations; it is not the auditor’s role to value fund assets.

Most importantly, it is the methodology behind the valuation that enables SMSF auditors to form an opinion that the asset was valued at market value. 

Where there is insufficient valuation evidence available due to the impact of COVID, SMSF auditors must consider qualifying both Part A and Part B of the audit report and lodge an auditor contravention report (ACR) if necessary.  

The ATO has said that where the absence of evidence is due to COVID, the contravention will not result in penalties. 

Related-party income 

Where the fund or a related entity has related-party transactions, SMSF auditors will be on full alert. Close scrutiny will see the auditor asking questions such as whether the rent is being paid at market value and are the lease terms conducted on an arm’s length basis.

And this is where the problems start.

Obtaining an independent rental assessment confirming rent is at market rates where negotiated incentives are in place will be problematic.

While the valuation will state the rent’s market value, it generally won’t refer to specific lease incentives provided under the agreement, allowing the auditor to confirm they are on commercial terms. 

An independent valuer or agent should verify any incentives provided to a related-party tenant to ensure they are on commercial terms and are similar to what is being offered in the marketplace.

The ATO has also said that the net income yield of commercial properties is not sufficient evidence on its own and is only appropriate where the tenants are unrelated. 

Without evidence to support any incentives provided, an identified shortfall in rent may be considered a breach of s 109 SIS and reportable to the ATO. The timing of rent payments and all lease-related payments, such as expenses, will also be checked to ensure they are on an arm’s length basis.

What about NALI? 

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

When rent is paid higher than market rates, a tax issue is generated as the investment is not maintained on an arm’s length basis.

As a result, all of the fund’s income from that property may be deemed 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. Ouch.

From an audit perspective, NALI is not a compliance breach but a tax issue, which results in management letter comments in most cases.

What can happen in practice?

With the commercial rental market in freefall, SMSF auditors will have difficulty understanding whether lease agreements containing incentives reflect arm’s length arrangements.

One recent example saw an SMSF trustee purchasing a commercial property for lease to a related party. They obtained a rental valuation, with the report noting substantial amounts of tenancy subsidies and free rental periods provided in the market due to business hardship and a lacklustre economy.

The valuation report stated that it was not uncommon for incentives such as low fee periods of $1 for six to 12 months to be offered.

The report then cited evidence of a tenancy provided at $1 for six months, followed by a rent of $600 for the next 18 months and reverting to the total market rate after 24 months.

Unfortunately, this arrangement was a related-party lease between father and son, providing no level of comfort to the SMSF auditor.

As a result, the report could not be relied upon as audit evidence, and the auditor would have to consider modifying their audit report and potentially lodging an ACR.

Sole purpose test

Section 62 SIS requires SMSF trustees to maintain a fund for the sole purpose of providing retirement benefits to members.

It is unlikely that a fund will meet the sole purpose test where anyone obtains a financial benefit when making investment decisions. 

Given the proposed rental arrangement, an additional question arises about the trustee’s real purpose behind investing. Was the property purchased to provide subsidised rent to a related-party business and, if so, how does this pass the sole purpose test?

Conclusion

The impact of COVID will trickle through the SMSF industry well beyond the 2021 and 2022 financial years. We can only speculate on how the market will fare as the federal government starts to withdraw its COVID support measures, such as the early release of super and JobKeeper.

While obtaining market valuations will be an ongoing headache, meeting the challenge to prove that related-party rent is on commercial terms due to COVID may be impossible if the market continues to react over short periods.

As always, the devil is in the documentation detail, which will allow SMSF auditors to find the equilibrium between compliance and commercial reality.

Shelley Banton, head of education, ASF Audits