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ATO takes hard line on in-house asset rules

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By Keeli Cambourne
October 24 2023
3 minute read
6 View Comments
chris levy aquila super smsfa gmx78h
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A recent announcement from the ATO on in-house asset rules has left many in the auditing sector stunned, claims a leading adviser.

Chris Levy, founder of Aquila Super, said during a recent auditor discussion group session, the ATO “dropped a bombshell” by clarifying the legislation does not support any form of rectification except for the disposal of the in-house asset.

Mr Levy said the ATO used an example of a residential house with a related party tenant.

 
 

“The offending asset was the house, not the lease or tenancy agreement,” he said.

“Therefore, removing the tenant and cancelling the lease did not, by itself, meet the specific rectification requirements explicitly stated in the Superannuation (Supervision) Industry Act 1993 (SIS Act).

“The ATO argued that the only acceptable course of action would be to sell the house.”

He said the ATO recently turned its attention to in-house asset breaches, and, more specifically, what a fund is required to do to resolve the breach satisfactorily.

He said the way trustees and advisers have typically dealt with a breach can be divided into two broad categories with the more drastic but cleaner option involving the sale or disposal of the offending in-house asset in whole or in part.

“The other more common option involves taking some sort of action to change the character of the asset so that it is no longer caught by the in-house asset net,” he said.

This may involve the removal of a related tenant from a residential apartment or restructuring the equity framework or management of a semi-related unit trust so members and associated entities no longer ‘control’ the trust.

“This action means the trustee can now assert that the underlying problem has been fixed and the investment is no longer considered an in-house asset,” Mr Levy said.

“The SMSF will likely still be subject to a contravention report for the initial in-house asset breach, but the ATO has to date accepted such an approach as satisfactory rectification.”

However, Mr Levy said the ATO’s announcement has cast doubt on the legal validity of this approach.

“The reaction of many was to race off to the legislation thinking that there was some mistake or that the ATO’s interpretation was overly strict and possibly mistaken,” he said.

“However, a literal reading of the relevant sections of the Act provides some solid legal basis to the ATO’s position.”

He continued that under section 82 of the SIS Act, an in-house asset breach requires a trustee to first prepare a plan to correct the in-house breach, and later in the same section to carry out that plan.

The requirements of this rectification plan are outlined in section 82(4), and state: “The plan must set out the steps which the trustee proposes…to ensure that:

(a) one or more of the fund's in-house assets held at the end of that year of income are disposed of during the next following year of income; and

(b) the value of the assets so disposed of is equal to or more than the excess amount”.

“The absence of any mechanism, other than disposal of the in-house asset itself, is striking,” Mr Levy said.

Although some SMSF professionals have suggested that changing an in-house asset’s character by removing the relative as a tenant may be an effective ‘disposal’ for the purposes of section 82, Mr Levy said the ATO may not approve of this approach.

“The implications of this ‘new’ position from the Regulator are potentially frightening for SMSFs that invest in assets,” he said.

“It is now even more incumbent on SMSF advisers to educate trustees of the rules and prevent in-house asset breaches from occurring in the first place.”

He continued that one of the bigger concerns over in-house asset breaches deals with business properties involving related tenants.

“Most accountants have a general understanding of the rules surrounding related party tenancies and take care to ensure all dealings are at arm’s length,” he said.

“What is less known by the average accountant is that the in-house asset exemption for business real property under section 71 requires a lease to not only be in place but that it be legally enforceable.”

Care should also be taken when dealing with semi-related trusts and companies, not just at the initial investment stage but over the life of the investment, he continued.

“We have seen these types of investments initially structured with careful diligence to avoid them being caught under the Part 8 associate rules, only to have the trust later become in-house by other unrelated investors withdrawing their money and/or resigning as trustee directors.”

Mr Levy concluded that the ATO does have some discretion to deem an in-house asset to not be one.

“Trustees could therefore seek to have the ATO exercise such discretion through the voluntary disclosure regime, with the goal of fixing the problematic issue without having to be forced to sell the asset as well,” he said.

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Comments (6)

  • avatar
    Technical Financial Wednesday, 25 October 2023
    I have always thought that the ATO had taken a pragmatic approach despite the legislation and the July 2012 NTLG minutes which Craig pointed out. 

    I had a recent case where an intended 13.22C trust invested in another entity as well as borrowings. One would think that with the 13.22C trust breaching 13.22D, the SMSF's unit holding in this 13.22C trust had to be disposed but the ATO through the voluntary disclosure scheme allowed the SMSF trustees to rectify by extinguishing borrowings and removing the ownership by the 13.22C in another entity.  

    This was as recent as a couple of years ago. Therefore, I would be interested to see whether the premise of a shift in ATO's stance is endemic throughout the ATO or just the stance of the ATO delegate attending the auditor discussion group. 
    0
  • avatar
    Had this exact issue with a new fund we audited 4/5 years ago where SMSF residential property was being leased to the daughter of the trustees. As soon as this was picked up the trustees were advised and installed an unrelated tenant.

    Accountant who provided the audit actually went to a training session where he asked a deputy commissioner in attendance for advice and she suggested the accountant make a disclosure to the ATO asking for their discretion for the fund to retain ownership which he did and on the basis:

    1. The daughter was actually paying MV rent
    2. The property was now leased to an unrelated tenant at MV

    The ATO considered the matter resolved and no disposal was required. For something of this magnitude where the trustees just hadn’t been given the correct advice/guidance initially I suspect the ATO will generally be pragmatic/receptive to such an approach. Of course, that may change if the trustees were deliberately seen to be breaching the SIS act/regulations!
    1
  • avatar
    I had this situation with a client about 10 years ago. I told the client he had to sell the property. I did a contravention report that stated the rectification would be to sell the property. The ATO went straight to the client and told him that he could just terminate the lease with his brother and didn't have to sell the property. As it was the client sold the property anyway. 
    0
  • avatar
    The ATO's position is clearly now too broad.  It is the "in-house asset" which must be "disposed" of, not necessarily the "asset" itself.  Both "in-house asset" and "asset" are defined in the SIS Act, but "disposed of" is not.  

    To "dispose" of something is a broader term than simply to "sell", and includes "to get rid of someone or something or deal with something so that the matter is finished."  So, it entirely consistent with the legislative intent that the trustee "deal with" the "in-house asset" during the next year of income.
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  • avatar
    The ATO clarified what a trustee must do to rectify this kind of in-house asset breach over 10 years ago. See NTLG super technical sub-committee minutes from July 2012. Following excerpt being relevant:

    "As it is the residential property the subject of the lease to the related party of the fund, rather than that lease, that is an in-house asset, the ATO considers that the cessation of a lease of an asset to a related party of the fund does not result in the in-house asset (the residential property) being 'disposed of' for the purposes of section 82 of the SISA. The residential property remains an asset of the fund after the cessation of that lease. Accordingly, cessation of the lease to the related party of the fund would not satisfy the requirements of section 82, notwithstanding that it might reduce the market value ratio of the fund's in-house assets to below the 5% limit."

    That is - you need to sell the property rather than kick out the related party to resolve the problem. 
    2
    • avatar
      The most significant excerpt of these minutes is "The ATO indicated that in situations with a similar set of facts where there was only a one-off breach, it is unlikely that the SMSF would be made non-complying."

      The breach can't be avoided whether the property is sold or the related-party lease is cancelled.  The question is whether the ATO has changed its tune with regard to rectifying the breach.
      0
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