You will have often heard about the need for super funds to conduct all dealings with related parties at ‘arm’s length’.
Most people think this means your SMSF must deal with EVERY other party at arm’s length, which basically means you need to make sure all transactions are done at market rates. Now, if you apply the arm’s length rule to all your transactions, you’ll never get into trouble. But by understanding how the arm’s length rule works, you will realise that you don’t need to apply it in every situation.
Cheap as chips
For example, suppose my self-managed super fund (SMSF) decides to purchase an asset I personally own, like a business property (it will need to be an asset that you are allowed to sell to the fund). In this case, most people assume that my super fund has to acquire this asset for the same price that I would obtain from someone I didn’t know – that is, at market rates. But it doesn’t. Theoretically, I could sell a business property to my fund for $1 if I wanted to. I could also lend my fund money at 0.1% to buy a house too, as long as that house isn’t owned by a related party. Now doing so will be hard and not necessarily in your best interest, but it’s not against the super law. I’ll explain why.
The arm’s length rule says that a ‘super fund’ must deal with every other party at an arm’s length basis.
However, a slightly different rule applies if the other party is related to your super fund. This rule says that if the other party is related to the super fund, then the transaction can’t be more favourable to the other party.
Put simply, your SMSF can’t sell a house to you for $1 because this is advantageous to you, not the super fund. But the super laws don’t stop you from selling a business property to the fund for $1 because this benefits the fund, not you, on a personal wealth level anyway.
So who is considered a related party? They include:
- All members of your fund;
- All relatives of your fund’s members;
- Any entity – for example, companies, trusts or partnerships – that the members or their relatives control or the law deems that they control.
How might transactions be more favourable to the other party?
Let’s go back to my example of my super fund buying an asset I personally own. If my super fund agrees to buy that asset for 100% more than a genuine arm’s length price, then clearly that might appear to be good for me.
Clearly such a transaction wouldn’t comply with the super law’s arm’s length rule.
The arm’s length rule for related parties does allow the two parties to deal in such a way that the super fund gets a great deal. For example, suppose my super fund took possession of one of my assets, but didn’t pay anything for it.
On the face of it, the super fund now has an asset for nothing. This is okay from an arm’s length perspective because the super fund has ‘won’.
The catch
However, Tax Ruling 2010/1 says that when a super fund acquires an asset for less than market value, then the difference between the market value and actual purchase price is deemed to be a super contribution, which has to be reported and assessed for excess contributions tax purposes.
So, if you sell a $500,000 apartment to your fund for $1, then $499,000 of it will be considered a contribution, and that’s clearly breaking the cap, meaning you’ll get slugged with a tax penalty.
Moreover, the Capital Gains Tax rules operate in such a way that I would need to pay CGT using an assumption that I had sold the asset to the super fund for an independently verifiable market price.
In most States and Territories, the respective Duties Acts work in the similar way if duty is payable on the transfer of an asset (for example, real estate). That is, duty is worked out on the deemed market value of an asset.
Super gearing
Now let’s apply this rule to Limited Recourse Borrowing Arrangements (aka super gearing or LRBA) – more detail about these arrangements can be found here.
Suppose your super fund has borrowed money from you (this is often referred to as ‘related party borrowing’). Can you charge your super fund a favourable interest rate? The Tax Office has dealt with this issue in Interpretative Decision 2010/162. It says that the arm’s length rules in the super laws allow your fund to pay a lower rate than what might be available from an arm’s length lender.
Further, this provision can apply for the life of the loan.
However, this Interpretative Decision doesn’t look at the favourable charging of interest from a super contribution perspective. In TR 2010/1, the Tax Office says “a contribution is anything of value that increases the capital of a superannuation fund provided by a person whose purpose is to benefit one or more particular members of the fund or all of the members in general.”
For example, the ATO says that if a lender forgives a debt, then a contribution has been made. Using this logic, I think you would find it difficult to argue that charging a lower LRBA interest rate wasn’t designed to increase the capital of your super fund or benefit you and the other members of your super fund and hence a contribution has been made.
So while theoretically you can lend money or sell an asset to your fund at a favourable rate, there are limitations on how far you can go due to the contributions caps.
Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.