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Navigating control in related party entities

By Shelley Banton
17 February 2022 — 6 minute read

An essential rule in navigating related party entities is that the SMSF and related parties determine how an entity is classified. While exceeding the 50% investment level can be readily calculated, the misunderstood issue of control or sufficient influence can lead to SMSF compliance issues.

Who is a related party? 

The definition of a related party (subsection 10(1) SIS) is anyone of the following: 

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  1. All members of the fund (as defined by the governing rules)
  2. Standard employer sponsors (who contribute under an arrangement between the employer and trustee)
  3. Part 8 associates of the members or standard employer sponsors (defined under Part 8 SIS – the in-house asset rules

While the first two conditions are reasonably straightforward, the Part 8 associate 'black hole' can confuse even the most experienced SMSF professional.

Section 70B SIS provides the answers to who is a Part 8 associate of individuals (who are the fund members), and these include:  

  • Relatives of each member and their spouses   
  • All other members of the SMSF  
  • All other trustees, both individual trustees or directors of the corporate trustee  
  • A partner in a partnership of each member  
  • Any spouse or child of those business partners  
  • Any company the member or their Part 8 associates control or influence  
  • Any trust the member or their Part 8 associates control  

Part 8 associates of standard employer sponsors are also related parties; they are typically hardcoded into old trust deeds, are less relevant and not covered here.

While it is critical to drill down into each definitional element to understand who gets caught as a Part 8 associate, we will focus on how a member or their Part 8 associates control or influence a company or trust.

Control of a company

SIS paragraph 70E(1)(a) states that a member of an SMSF will be considered to control a company if the company is sufficiently influenced by the member and/or a Part 8 associate of that member. 

The situation occurs where a majority of the company's directors have become accustomed, obliged or expected to act under directions, instructions or wishes of the member and/or Part 8 associates of the member.   

Determining this is challenging and requires understanding the relevant facts, circumstances, and practical testing. It also depends on how the entity's decisions are made.  

By way of example, a company or a trustee company with two directors may be controlled by one director even though the appointment of the other created the impression that the board was independent. Annual minutes or other company communications may also provide appropriate audit evidence.

Of course, control also includes where a member and/or a Part 8 associate of that member have a majority voting interest in a company. 

A copy of the constitution can answer whether they can cast or control the casting vote or have more than 50% of the maximum votes.

Sometimes, SMSF auditors may have difficulty deciding whether there is sufficient influence over a company despite the indications. Under these circumstances, the auditor may lodge an auditor contravention report (ACR) …. giving the ATO the casting vote.

The important thing is control over the company. Unlike a partnership where every partner is a Part 8 associate, the difference is that a company is not automatically a Part 8 associate.

Control of a trust

Under s70E(2) SIS, an entity controls a trust if:

  • A group in relation to the entity is entitled to a fixed entitlement of more than 50% of the capital or income of the trust 
  • The trustee of the trust, or a majority of the trustees of the trust, is accustomed or under an obligation (whether formal or informal) or might reasonably be expected, to act in accordance with the directions, instructions or wishes of a group in relation to the entity
  • a group in relation to the entity is able to appoint or remove the trustee, or a majority of the trustees, of the trust 

The Part 8 associate net widens once the definition of a group related to an entity is considered, encompassing an individual, a company, a partnership, or a trust.

At this point, underestimating the importance of the deed and the corporate trustee's constitution is a recipe for an SMSF disaster. The reason is that these documents can provide significant insight into who's controlling the trust by voting rights, the number of units held and who can change the trustee.

Once again, minutes and other documentation may also indicate that one or more entities are acting as a group and controlling the trust.

Checklist for identifying related entities

The gateway to understanding whether an entity is related requires these steps to be followed:

  1. Identify who the related parties are 
  2. Calculate the proportion of shares or units held in the related entity 
  3. Check whether the fund or related parties hold a controlling interest or can they sufficiently influence the decisions of the entity – such as by having a casting vote 

Once identified, related party entities require further procedures:

  1. Review the entity's financial statements for borrowings, non-arm's length dealings and that all distributions paid at the end of the financial year 
  2. Determine whether there are loans, investments, or leases to related parties and do any IHA exemptions apply (such as r13.22c entities) 
  3. Identify IHA, calculate the % and obtain a written plan by the trustees to dispose of the excess down to 5% or less by the next financial year 

 Consistently applying this process across SMSF transactions will help identify potentially related party entities, allowing SMSF professionals to tread carefully and ensure regulatory compliance.

In-house assets

The in-house asset (IHA) rules cleverly interact with Part 8 SIS to provide a holistic approach to SMSF compliance. Section 71(1) SIS defines an IHA as:

  1. An asset of the fund that is a loan to a related party of the fund 
  2. An investment in a related party of the fund 
  3. Or an asset of the fund subject to a lease or lease arrangement between a trustee of the fund and a related party of the fund 

A fund can invest in any one of these IHA as long as the value of the in-house asset is 5% or less of the total fund assets.

Exceeding the 5% IHA level is a breach of s82 SIS, and the trustees must prepare a written plan that sets out the steps to reduce the limit of their IHA to 5% or less before the next financial year.

If the fund cannot dispose of assets to reduce the IHA level back to the 5% complying level, the fund must dispose of the IHA to meet the governing legislation.

A carve-out exists in s71 SIS, allowing a fund to invest in a related entity as long as it complies with r13.22C and r13.22D SISR. These are called non-geared unit trusts and companies (NGUT).

NGUTs that meet the r13.22C and r13.22D requirements at the time of purchase and throughout the year are exempt from the in-house asset rules.

Another bonus is that the fund can acquire units in NGUT at market value without breaching s66 – acquisition of assets from a related party.

The problems start when what appears to be an unrelated entity changes the status to a related entity without meeting the requirements of r13.22C and D and quickly becomes an IHA.

Problems in practice

A fund owning 50% of a unit trust may appear unrelated on paper. While the other investor does not meet the description of a related party or Part 8 associate, the unrelated entity can still breach the IHA rules.

By way of example, if the unrelated trust was a property development unit trust, controlling the corporate trustee could effectively be done by one of the directors managing the property development.

Where the controlling director is also an SMSF member and all property development decisions are under their control, the unrelated unit trust becomes a related party of the fund.

As borrowings typically fund property development entities, they will not meet the requirements under r13.22C and become an IHA of the fund.

Due to the size and nature of these investments, they are traditionally more than 5% of fund assets. Where the fund could not reduce the level of IHA to 5% or less by the following year, the fund will be required to dispose of the asset.

Conclusion

Navigating control in related party entities is critical to ensure that an SMSF stays on the compliance path.

The legislative complexities surrounding related parties means that SMSF trustees investing in closely held entities must rigorously ensure they cannot control or sufficiently influence the entity.

SMSF professionals should be aware that related party control over an unrelated entity can quickly lead to SMSF chaos.

Shelley Banton, head of education, ASF Audits 

Navigating control in related party entities
shelley
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