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SMSF: Dealing at arm's length
The trustee must "deal at arm’s length with the other party" is a requirement that underpins all SMSF transactions.
While this ensures that SMSFs are not used as a scheme to artificially enhance concessionally taxed super benefits, failure to adhere to some aspects of this requirement may result in inadvertent contraventions with unintended tax consequences.
The commercial basis of a transaction extends beyond market valuations. The terms and conditions including process and documentation should also reflect commercial practices and procedures given similar situations.
This article provides an explanation of the arm’s length dealing concept, drawing upon provisions in relevant legislations, ATO Rulings and published information
Section 109 SIS Act: The superannuation trustee of an investment transaction must deal with the other party on an arm’s length basis, or on terms no more favourable to the other party than would have applied under normal arm’s length circumstances.
Section 295.550 Tax Act: SMSF parties not dealing at arm’s length and deriving income more than the amount the SMSF might have been expected to derive if the parties had been dealing at arm’s length is NALI. This is applicable to income attributable to both inflated earnings and reduced (including nil) outgoings or expenses. NALI requires a scheme as a prerequisite but any arrangement can amount to a scheme.
The above provisions together with the sole purpose test are the important anti-avoidance provisions applicable to SMSF investments and income.
The ATO has also expressed NALI concerns in relation to related party transaction e.g. related party SMSF property development.
What is dealing at arm’s length?
Dealing at arm’s length refers to the “arm’s length basis” of the transaction, not the parties.
However, where the parties to the transaction are related (including members, standard employer sponsor and Part 8 Associates), there is a higher onus on the trustee to substantiate the arm’s length nature and basis of the transaction. In SMSFRB 2020/1, the ATO considers that “there is an inference related parties will not deal with each other at arm’s length, but this can be reversed”. This follows from TR2006/7, which states that where the relationship is such that one party has the ability to influence or control the other, it will suggest that the parties may not be dealing at arm’s length, but it will not be determinative. It is a factor to be considered.
TR2007/1 also provides “parties that are not at arm’s length can deal with each other at arm’s length in relation to a transaction and parties that are at arm’s length can deal with each other in a way that is not at arm’s length.”
2. Meaning of “arm’s length”
The ATO has provided the following interpretation:
• Arm’s length means investments must be made and maintained on a commercial basis. A test would be whether a prudent person, acting with due regard to his or her own commercial interest, would have agreed to the terms (ATO “Terms We Use”)
• Parties are dealing with each other at arm’s length in relation to a transaction if the independent minds and wills of the parties are applied to the transaction and their dealing is a matter of real bargaining (TR2006/7)
The emphasis is on commercial basis, the terms and conditions must be comparable to those arrived at after real bargaining, and acceptable to an objective prudent person who looks after their own interest.
The terms and conditions of an arm’s length dealing would be different for each type of transaction but market value permeates all commercial transactions.
Market value is defined in the SIS Act and the concepts of “willing buyer” and "willing seller" denote the bargaining principle.
3. Market value
The purchase and sale price of fund assets should always reflect true market value and income from fund assets should always reflect a true market rate of return.
• Market value is defined in section 10 of the SIS Act as follows:
Market value in relation to an asset means the amount that a willing buyer of the asset could reasonably be expected to pay to acquire the asset from a willing seller if the following assumptions were made (a) that the buyer and the seller dealt with each other at arm’s length in relation to the sale; (b) that the sale occurred after proper marketing of the asset; (c) that the buyer and seller acted knowledgeably and prudentially in relation to the sale.
• The Explanatory Statement to the NALE Legislation also provides some guidance. An arm’s length price may be accepted if it falls within a range of commercial prices. For example, loans may be available at different interest rates based on a range of factors. Accordingly, an SMSF may be able to apply an acceptable commercial rate of interest to a loan within a band of rates available to it on an arm’s length basis.
Accredited professional valuation, ATO safe harbour terms for LBRA, commercial lenders and authorised deposit-taking institutions rates and practices in similar situations may be used in the valuation process.
4. Documentation and process
The commercial basis of a transaction also includes proper documentation and implementation.
For example, a LRBA loan from a related party must be implemented by proper documentation including legally binding loan agreement, resolutions and holding trust establishment documents. The borrowing must be permitted by the governing rules of the SMSF. Restitution actions should also be considered where repayments have fallen behind.
A recent example in the ATO SMSFRB 2020/1 highlighted the importance of the documentary aspect. An SMSF owns units in a SIS Reg 13.22C private unit trust which leases business real property (BRP) to a related party on commercial terms. The lease agreement does not have a continuation clause. At the end of the five-year term, the lease ceases to be binding and in the absence of a renewal, the BRP will become an in-house asset of the fund and NALI may also potentially apply.
Using the commercial lease as an example, the process and documentation will include:
• A binding lease agreement
• Market rate of rent and terms e.g. rent deposits
• Regular monthly or fortnightly rent payment
• Rental review
• Any variation to be documented
• Follow up actions if rent not paid
5. Record keeping
In SMSFRB 2020/1, all SMSF transactions should be documented to ensure:
• there is proof of arm’s length dealings
• the arrangement put in place reflects the legal status
• the arrangement is permitted by the SMSF’s deed and investment strategy.
SMSF as a private retirement savings vehicle offers flexibilities and advantages for the member to preserve and enhance their retirement benefits. Members also have better control over their fund’s investments through their investment strategy and the ability to respond to market volatilities in the most efficient and timely manner.
The SMSF arm’s length dealings requirement highlights the importance of proper documentation and trustee resolutions, records to demonstrate the commercial basis of each dealing with reasons as to actions taken and paper trails.
SUPERCentral, with our associated law firm Townsends Business & Corporate Lawyers, provide high level SMSF advisory and documentation services. For further assistance, please contact us on 02 8296 6266.