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If you are a trustee of your own self-managed super fund, you’ve probably heard of the ‘arm’s length’ rule.
The concept of ‘arm’s length’ is familiar to businesses the world over. To ensure business transactions are conducted at commercial market values buyers and sellers must act independently, without colluding and without one party influencing the other.
So how does this concept apply to your SMSF?
Broadly speaking, any investments by an SMSF must be made and maintained on an arm’s length basis. That is, all transactions must be conducted at commercial market rates. Buyers and sellers must act independently.
Which SMSF transactions are affected?
SMSFs must ensure that all their investments must be conducted and maintained at arm’s length, including:
- asset acquisitions
- asset sales
- investment returns
- borrowing/loan arrangements at commercial rates of interest.
This is not as straightforward as it might seem, given that many SMSFs are family affairs. They are also popular with small business owners who may own and lease back business property in their fund. The arm’s length rules around transactions involving ‘related parties’ are strict.
Some of the biggest challenges for SMSF trustees regarding the arm’s length requirements are the rules about related parties. A related party is not just a relative or another member of your SMSF, it includes any of the following associates:
- the relatives of each member
- the business partners of each member
- any spouse or child of those business partners
- any company that the member or their associates control or influence
- any trust that the member or their associates control.
Employers who contribute to a member’s superannuation are also considered related parties.
Assessing an asset’s market value
Problems arise if related parties sell an asset to an SMSF at below market value. That transaction would be in breach of the arm’s length rule.
An example. John and Elaine own an investment property – a small apartment – through their SMSF. They receive an offer on the apartment from an unrelated party at market value, but they reject the offer. They want to help their daughter Jessica by selling her the apartment at a much lower price, but they are advised this would be in breach of the arm’s length rules.
The ATO provides valuation guidelines for SMSF assets to help you comply with the arm’s length requirements if your fund is buying or selling assets from or to related parties. They are summarised in the table below.
|Collectables and personal use assets when sold or transferred to a related party.||The market value of these assets must be determined by a qualified independent valuer.|
|Transfers of other assets (excluding collectables and personal use assets) between related or unrelated SMSF parties.||All acquisitions and disposals must be made at market value, based on objective data.|
Non-arm’s length income
The concept of arm’s length may also apply to some types of income in your fund. Any income earned through your SMSF by activities conducted on a non-arm’s length basis is called non-arm’s length income (NALI) and is taxed at the highest marginal rate (45%) instead of the usual 15% concessional superannuation rate.
NALI originally applied to income or capital gains greater than would be the case in an arms-length transaction. But recent amendments to the law now also include as NALI income or capital gains where fund expenses incurred in producing the income or gains are less than arm’s length amounts. These changes apply to income or gains derived from 1 July 2018.
The upshot is that non-arm’s length income means your SMSF is not allowed to invest in a way that favours the SMSF. The rules aim to make SMSFs invest so their income is neither too much nor too little.
The following case study from the ATO highlights the dangers of non-arm’s length transactions involving limited recourse borrowing arrangements (LRBAs).
It’s a complex area so to check which factors determine whether income is non-arm’s length, see the ATO website or seek professional advice.
It’s important to ensure that all your SMSF transactions are arm’s length dealings to ensure your compliance with Australian superannuation legislation. The ATO can impose a range of penalties for non-compliance, depending on the seriousness of the breach.
The information contained in this article is general in nature.