Self-managed superannuation funds, or SMSFs, can offer a great deal of flexibility. They allow members to make investments and enter into arrangements that may not be available through retail or industry super funds.
That flexibility also comes with serious responsibilities. SMSF trustees need to make sure the fund’s decisions and transactions comply with superannuation law.
Two areas that are especially important are:
- the sole purpose test
- the arm’s length requirements under both superannuation and tax law
The sole purpose test
The sole purpose test requires an SMSF to be managed for the sole purpose of providing retirement benefits to its members.
Some SMSFs may have dealings with related entities or make related party investments, although these arrangements are subject to strict limits. In these situations, trustees need to make sure they are acting in the best interests of the fund members, rather than meeting the needs of family members or other external parties.
Example, investing in a related business
Sachin and Deepthi have an SMSF with a total balance of $1.2 million. Their son, Hardik, started a business three years ago through a company structure and has asked his parents to invest $50,000 from the SMSF into the company.
Hardik is committed to the business, although it has experienced cash flow issues and is not yet growing strongly or making a profit.
While the proposed investment may fall within the 5% in-house asset limit, the key question is whether Sachin and Deepthi would make the same investment if the business were unrelated to them.
That is the real test. If they are putting their son’s interests ahead of the interests of the fund members, they may be breaching the sole purpose test.
Key point
- trustees must always ask whether an investment is being made to support members’ retirement outcomes, not to help a relative or another connected party
Arm’s length requirements
SMSF trustees must also make sure all arrangements are conducted on arm’s length commercial terms.
This is especially important where dealings involve:
- fund members
- relatives
- related businesses
- related trusts or entities
Where an arrangement is not at arm’s length, trustees may face superannuation law penalties. In some cases, the fund’s income may also be taxed at a higher rate.
Example, SMSF-owned commercial property leased to a related business
If an SMSF owns commercial property and leases it to a related party business, the rent must be set on proper commercial terms.
This should be supported by evidence, such as a rental appraisal from a qualified professional, for example a real estate agent, when the lease is entered into.
The lease agreement should:
- be in writing
- clearly set out who is responsible for outgoings and maintenance
- be prepared by a legal professional
Example, work completed on an SMSF property by a member or related party
SMSF trustees should get professional advice before any work is carried out on SMSF property by a member or related party.
All arrangements involving related parties need to be commercial and properly documented.
This includes:
- where a related building company is used, the SMSF must pay market rates, the same as the general public
- the pricing should be supported by documentation so the fund auditor can verify it
- where members who are also trustees do work personally, strict rules apply to whether they can be paid
- all materials should be purchased directly by the SMSF, not by individual members
Why this matters
SMSFs can be effective and flexible vehicles for building retirement wealth, although trustees need to approach related party arrangements very carefully. Even where an arrangement seems reasonable, it can create compliance issues if it is not clearly aligned with the fund’s retirement purpose or not conducted on commercial terms.
Key takeaway
Before entering into any transaction involving related parties, especially where SMSF-owned property is involved, trustees should pause and get advice early. A proper structure, clear documentation and commercial pricing can make a major difference.
If you have questions or concerns, please do not hesitate to contact our office to speak to one of our team.
