Applying the magnifying glass to section 109 — Part 2
Recent amendments to section 295-550 of the Income Tax Assessment Act 1997 have focused a spotlight on non-arm’s length dealing within SMSFs and the tax consequences of underpaying certain expenses to benefit the fund. Section 109 has not changed at all. But this legislation contains nuances that warrant revisiting today.
To ‘make’ an investment — s109(1)
Let us now return to the first two parts of section 109.
Subsection 109(1)(b) permits an SMSF trustee to make an investment on non-arm’s length terms if the superannuation fund benefits by the transaction.
This is an “entry level” rule that applies to non-arm’s length acquisitions. Subsection 109(1)(b) does not consider the ongoing maintenance of an investment in the fund. Nor does it preclude the operation of other compliance provisions.
It is therefore important not to use this rule of thumb in isolation.
Consider the following example:
Bob’s SMSF, The Money Machine Super Fund, acquires 10,000 shares from Bob in a rapidly expanding private company of which Bob and his nephew are the sole directors.
The shares comprise 2 per cent of the fund’s total assets. Bob wants to do the SMSF a favour and minimise his own taxable income, so he sells the shares at $3,000 less than the current issue price being offered to other investors.
The terms for Bob are less favourable than would be expected had the transaction occurred between the SMSF and an arm’s-length party. The SMSF has benefited in the acquisition.
There is no breach of section 109.
However, notwithstanding a green light for section 109, The Money Machine Super Fund has contravened several over superannuation provisions that require a standard of arm’s-length dealing.
Section 66 — the ‘market value’ requirement
The transaction has failed the exception in s66(2)(a), which permits an SMSF to acquire listed shares in a related party at market value. Similarly, it fails the exception to acquire an in-house asset under s66(2A), which also requires the investment to be purchased at market value.
“Market value” is defined by s10 of the Superannuation Industry (Supervision) Act 1993 as the amount that a willing buyer would pay to acquire the asset if:
a. The buyer and seller dealt with each other at arm’s length in relation to the sale.
b. The sale occurred after proper marketing of the asset.
c. The buyer and the seller acted knowledgeably and prudentially in relation to the sale.
In other words, “market value” is the price established in an arm’s-length transaction. By failing to deal at arm’s length (even if to benefit the SMSF), the fund’s trustee has improperly acquired an asset from a related party, in breach of section 66.
Regulation 13.22C — the arm’s-length requirement
The long-reaching principle of arm’s-length dealing in the SIS Act may extend even further. Imagine that Bob’s company is in fact a “non-geared” entity to which regulation 13.22C applies. Investment in this company is therefore not considered an in-house asset, provided certain restrictions are complied with — including the prohibition against borrowing money, extending a loan or holding an interest in another entity.
A less well-known condition within regulation 13.22D is that such entities must deal at all times on an arm’s-length basis. If this related company were to issue shares to Bob’s SMSF at a discount, the company will be forever tainted for the purpose of regulation 13.22C and investments in this entity will become in-house assets.
Section 62 — proper purpose
The sole purpose test in s62 must always be considered in non-arm’s length transactions. The first question to ask is, “why?”
Even if the SMSF appears to benefit from the transaction, there may be an underlying motivation that is not in the interest of retirement savings. As seen in Scott v Commissioner of Taxation (No 2) 14 ATD 333, the court stood back from a non-arm’s length transaction which benefited the super fund to find that the activity was not for a proper purpose.
In Bob’s case, his decision to sell the shares at below market value was partly motivated to reduce his own taxable income. Bear in mind, however, that the sole purpose test is an objective assessment based on the available facts. If your SMSF auditor has no reason to think that Bob’s motivation for non-arm’s length dealing is to minimise his personal tax, he will fly under the s62 radar. Ordinarily, it is the more aggressive (and therefore more evident) strategies that attract scrutiny under s62.
Section 109 is a narrow provision.
Subsection 109(1A) is disappointingly vague and the whole provision is complemented by many other parts of the law. It is critical that SMSF practitioners approach both non-arm’s length acquisitions and investment maintenance with a view to the whole body of superannuation legislation.
It is also important to remember that the well-known rule “at arm’s length or benefit the SMSF” only applies at the investment acquisition level. Where the trustee is required to actively deal with the investment going forward, they must do so on arm’s-length terms.
Naomi Kewley, managing editor, Peak Super Audits
To read Part 1 of this article, click here.