The correct approach is crucial, especially since IHA breaches are rated as high risk by the ATO and represent 17 per cent of all auditor contravention reports (ACRs) submitted to the ATO by SMSF auditors.

One of the reasons for the ATO’s intense scrutiny of IHA is that it may be hiding illegal early release.

The meticulous process of identifying IHA within SMSFs requires a comprehensive understanding of the relevant definitions and criteria outlined in the legislation.

Overview of IHA breaches

s71 SIS does not allow a fund to invest in an IHA exceeding 5 per cent of total fund assets that include:

1. An asset of the fund that is a loan to a related party of the fund.
2. An investment in a related party of the fund.
3. An asset of the fund subject to a lease or lease arrangement between a trustee of the fund and a related party of the fund.

A fund can invest in any of these IHAs if the value of the IHA is 5 per cent or less of the total fund assets.

A common mistake is using net fund assets instead of total fund assets, resulting in an incorrect IHA percentage.

Also crucial for assessing compliance and calculating a fund’s IHA ratio is understanding the assets excluded from being an IHA:

1. A life insurance policy.
2. A deposit with an approved deposit-taking institution.
3. Business real property leased to a related party under a lease or lease arrangement.
4. An investment in a widely held trust.
5. An investment in a related entity that meets the requirements of r13.22C.

Identifying related parties

Identifying related parties is the first step in determining whether an asset is an IHA. The definition of a related party (subsection 10(1) SIS) is any one of the following: 

• All members of the fund (as defined by the governing rules).
• Standard employer sponsors (who contribute under an arrangement between the employer and trustee).
• Part 8 associates of the members or standard employer sponsors (defined under Part 8 SIS – the IHA rules).

While identifying fund members and standard employer sponsors is relatively straightforward, recognising Part 8 associates introduces additional complexity.

A practical tip is to start from the SMSF member and progressively work outward towards the entity associated with the SMSF. It involves tracing members’ connections to various entities and assessing whether they meet the Part 8 associate criteria.

Attempting to work backward may introduce unnecessary complexity and confusion into the identification process.

Demystifying how sections 70B, 70C, and 70D of SIS apply under Part 8 is also essential for accurately identifying related parties of fund members.

Section 70B SIS

Section 70B provides the answers to who is a Part 8 associate of individuals (who are the fund members), and these include: 

• Relatives of each member and their spouses.  
• All other members of the SMSF. 
• All other trustees, both individual trustees or directors of the corporate trustee.
• A partner in partnership with each member. 
• Any spouse or child of those business partners. 
• Any company the member or their Part 8 associates control or influence .
• Any trust the member or their Part 8 associates control. 

The broad scope of relationships captured under s70B requires a thorough examination of family ties, business affiliations and, most importantly, companies and trusts controlled or influenced by the member or their Part 8 associate.

The ATO, in particular, is concerned about the control and influence that a member or their Part 8 associate may exert over an entity.

Control of a company

SIS paragraph 70E(1)(a) states that a member of an SMSF will be considered to control a company if the company is sufficiently influenced by the member and/or a Part 8 associate of that member. 

The situation occurs where a majority of the company’s directors have become accustomed, obliged or might reasonably be expected to act under directions, instructions or wishes of the member and/or Part 8 associates of the member.  

Identifying control requires thoroughly understanding the relevant facts, circumstances, and practical testing.

One common scenario is a company with two directors, where one director exerts significant influence despite the appearance of board independence. Annual minutes or other company communications may be valuable in assessing control within such a company.

Control can also manifest when a member or their Part 8 associate holds a majority voting interest in the company, enabling them to cast or control the casting vote or possess more than 50 per cent of the maximum votes.

The company’s constitution serves as a key document in determining the extent of control, providing insights into voting rights and decision making.

Control of a Trust

Under s70E(2) SIS, an entity controls a trust if:

• A group in relation to the entity is entitled to a fixed entitlement of more than 50 per cent of the capital or income of the trust.
• The trustee of the trust, or a majority of the trustees of the trust, is accustomed to or under an obligation (whether formal or informal) or might reasonably be expected to act in accordance with the directions, instructions or wishes of a group in relation to the entity.
• A group in relation to the entity is able to appoint or remove the trustee, or a majority of the trustees, of the trust.

The definition of a group related to an entity widens the Part 8 associate net because it encompasses an individual, a company, a partnership, or a trust.

Underestimating the importance of a trust deed or the corporate trustee’s constitution can have dire consequences for an SMSF. These documents serve as critical sources of information regarding control structures, voting rights, and trustee removal and appointment within the trust.

Once again, minutes and other documentation may also indicate that one or more entities are acting as a group and controlling the trust.

Sections 70C & 70D SIS

While these sections of SIS also help identify a related party, they should be applied only after careful consideration.

Section 70C refers explicitly to a standard employer-sponsor and refers to SMSFs with such arrangements.

Section 70D covers partnerships and is irrelevant for identifying a Part 8 associate of the member because the member is an individual, not a partnership.