Property investment within SMSFs remains a popular strategy for building retirement wealth. Navigating SMSF property compliance, however, requires a holistic approach to ensure that SMSFs operate within the legal framework administered by the ATO and ASIC.
One of the problems is that SMSF trustees investing in property do not appreciate how the superannuation rules interact. Areas that can cause the most concern are the sole purpose test, the non-arm’s length income (NALI) provisions and property development.
The sole purpose test
The sole purpose test lies at the heart of a complying SMSF. It mandates that an SMSF must be maintained solely to provide retirement benefits to its members or their dependents in the event of a member’s death.
Until then, SMSF assets must not be misused for personal or business purposes unrelated to retirement benefits.
Breaches of the sole purpose test can have severe repercussions because an SMSF can risk losing its complying status and be subject to higher tax rates.
Non-compliance may arise from various scenarios, such as:
- occupying residential property by a related party for personal purposes
- undertaking property development activities where transactions are not at arm’s length
- not leasing business real property at market rates if used by related parties
Where the trustees of an SMSF are involved in property development ventures in various capacities, they must demonstrate that their decision-making is solely pursuing the retirement purpose of the SMSF and is not influenced by other goals or objectives concerning those business or other entities.
Non-arm’s length income (NALI)
NALI is another critical area of property compliance for SMSFs. The NALI provisions target income derived from arrangements not conducted on commercial terms. The provisions act as a powerful deterrent against arrangements that could unfairly increase member entitlements.
Where income is classified as NALI, it is taxed at the highest marginal rate instead of the concessional superannuation tax rate of 15%.
Identifying NALI involves examining transactions to ensure they are conducted on arm’s length terms. For example, if an SMSF acquires an asset for less than its market value or receives income under non-commercial terms, such arrangements may be deemed non-arm’s length triggering the NALI provisions.
ATO flags property development issues
NALI provisions are particularly relevant in the context of property development projects. The ATO has flagged concerns about property development arrangements where income gets diverted to SMSFs through non-arm’s length dealings.
For instance, SMSFs may hold direct or indirect interests in entities that invest in property development projects that engage in non-arm’s length transactions, such as entering into loans with related parties at a 0% interest rate, to maximise profits.
No specific prohibitions prevent an SMSF from investing directly or indirectly in property development. It can be a legitimate investment for SMSFs if the fund’s property development activities comply with the superannuation legislation.
The ATO, however, is concerned about the structure of certain schemes and arrangements that divert income into super, creating potential breaches of the sole purpose test, other SIS issues and NALI.
The ATO has provided guidance to SMSFs through its regulatory updates cautioning that care needs to be taken by SMSF trustees.
Joint ventures
The ATO has affirmed that a joint venture (JV) agreement involving related parties is an ‘in-house asset’. As a result, the SMSF must hold a proprietary interest in any real property being developed so that the ATO is comfortable with the SMSF investment being ‘in’ that property and not an investment ‘in’ the related party.
One of the leading indicators that the investment may be an in-house asset is that the fund provides capital for the joint venture and has no other rights than receiving a return on the final investment. The ATO has flagged that this will depend on the terms of the JV.
Where outside influences affect the trustee’s decision, such as ceasing to pay a pension to make a cash injection into a struggling property development venture, a contravention of the sole purpose test may occur.
The SMSF should not be involved in ensuring the success of a property development joint venture at its peril.
Ungeared entities
Investing in ungeared entities is another area where compliance with the requirements is complex. Ensuring the ungeared entity does not borrow, all transactions are at arm’s length, any related party acquisitions are at market value, and the entity does not operate a business can avoid the investment becoming an in-house asset. Once an in-house asset, the investment can never be returned to its former exempt status, even if the trustee fixes the issue/s that caused the assets to cease meeting the relevant conditions.
It can be difficult, therefore, for SMSFs to meet and maintain these conditions while undertaking property development investments.
Special purpose vehicle
The ATO has now set a higher bar for property development schemes by focusing on a 'controlling mind'. It makes the decisions for one or more property development groups by selecting the project and establishing an SPV who are typically the members of the fund.
The ATO has adopted a broader approach and is less prescriptive about specific arrangements and structures that could potentially fail SISA compliance with property development.
The ATO has acknowledged that non-arm’s length dealings by any party, with respect to any step in relation to a scheme, can give rise to NALI as defined in the Tax Act.
It gives the ATO a much wider net to cast, which ensures that trustees cannot circumvent the rules and can try to get more money into an SMSF.
Conclusion
Understanding the connections between NALI and the sole purpose test is crucial for an SMSF’s successful and compliant operation.
SMSF trustees must ensure that their funds are maintained exclusively for retirement purposes and that all transactions are conducted on arm’s length terms. Non-compliance with these requirements can lead to severe consequences, including significant tax penalties and potential disqualification.
Shelley Banton is Head of Education at ASF Audits. Read more articles in this SMSF property development series.