Applying the magnifying glass to section 109 — Part 1

The “arm’s-length rule” is familiar territory for SMSF practitioners. A well-known principle that keeps many swimming between the flags is that fund trustees must deal either at arm’s length or on terms that benefit the SMSF.

This is a good starting point from which to approach section 109 of the Superannuation Industry (Supervision) Act 1993. However, as a rule of thumb, it is not entirely accurate. Indeed, a closer look at this provision reveals a far more paradoxical story.

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What does the legislation say?

In basic anatomy, section 109 has three parts.

The first two parts are linked. They address mutually exclusive situations in which an SMSF trustee may undertake investment transactions with a non-arm’s length party.

The first part — s109(1)(a) — states:

A trustee… must not invest… unless the trustee… and the other party to the relevant transaction are dealing with each other at arm’s length in respect of the transaction.

The second part — s109(1)(b) — provides:

A trustee… must not invest… unless both:

The trustee… and the other party… are not dealing with each other at arm’s length in respect of the transaction;

and

The terms and conditions of the transaction are no more favourable to the other party than those which it is reasonable to expect would apply if the trustee… were dealing with the other party at arm’s length in the same circumstances.

The third part — s109(1A) — is separate. It addresses the requirement to maintain an investment where the SMSF is dealing with a non-arm’s length party:

If a trustee… during the term of the investment… is required to deal… with another party that is not at arm’s length… the trustee… must deal… as if the other party were at arm’s length with the trustee.

There is a key distinction here. When making an investment transaction, the SMSF trustee must either act on an arm’s-length basis or on terms favourable to the SMSF. When it comes to dealing with an existing investment, however, the trustee is restricted to arm’s-length terms only. The trustee has no liberty to act in a non-arm’s length manner to benefit the fund.

Let’s have a closer look at the various parts of section 109.

To ‘maintain’ an investment — s109(1A)

Subsection 109(1A) was introduced to complement subsection 109(1) to ensure that the arm’s-length principle would extend beyond initial acquisition to ongoing maintenance associated with an investment. The explanatory memorandum explains:

Subsection 109(1A) introduces a requirement that investments must at all times be maintained as if they were arm’s-length investments. This works in conjunction with existing section 109 which ensures that all dealings regarding entering into an investment are also carried out on an arm’s-length basis.

Regrettably, the legislation intended to achieve this object is vague.

It is weakened by one particular phrase.

The arm’s-length prescription for ongoing maintenance only applies if the SMSF trust is required to deal with the related party regarding the investment. If the SMSF is not required to deal with the investment on an ongoing basis, section 109 simply will not apply.

What is meant by “required to deal” is unclear. The ATO is of the opinion that “to deal” encompasses an SMSF’s whole activity in relation to an investment, irrespective of whether that conduct is carried out under a specific agreement.[1] The ATO also claims that being “required” to deal in the context of section 109 refers to the ordinary commercial and fiduciary obligations of an SMSF trustee.[2]

This would create a comfortably large umbrella requirement for arm’s-length maintenance.

It would capture the following passive behaviours by an SMSF trustee:

• Allowing trust distributions owing to the SMSF to go unpaid;
• Permitting a controlled trust or company to extend non-arm’s length loans to other entities;
• Permitting a controlled trust or company to register a charge over the entity’s assets.

Effectively, s109(1A) would be contravened by the non-arm’s length dealing of a related unit trust or company — action one step removed from the SMSF trustee’s own actions.

However, the Administrative Appeals Tribunal in Montgomery Wools [2012] AATA 61 did not share the ATO’s convictions. In the words of senior member J L Redfern:

“Even if I was of the view that ‘required to deal’ should be given a broad meaning to simply cover dealings with the related-party investment by the trustee, Montgomery Wools [the SMSF trustee] was not required to deal with the units… There was no sale of dealing in the units, but rather the underlying investment owned by [the related unit trust].”

“Required to deal” in the AAT’s view did not accommodate the trustee’s passive decision to let the unit trust operate in a non-arm’s length fashion. The requirement to deal indicates the need for positive action by the SMSF trustee, due to obligations under an agreement. The non-arm’s length behaviour of a related entity in which the fund has invested will not contravene this provision.

Subsection 109(1A) is therefore quite narrow in its application.

Beware, however, if the SMSF has a related-party investment governed by an agreement that prescribes ongoing positive action by the trustee (such as a loan agreement or commercial lease), it is reasonable to assume that the trustee is “required to deal” with that asset. This will invoke the arm’s-length requirement for ongoing maintenance and will apply even if non-arm’s length dealing benefits the SMSF. 

The maintenance of a related-party LRBA at below-market interest rates or the continuation of a commercial lease at above-market rent is therefore likely to contravene s109(1A).

Naomi Kewley, managing director, Peak Super Audits

[1] See SMSFR 2009/3 paragraph 150.

[2] See SMSFR 2009/3 paragraph 151.