1.0 Audit Procedures for Holiday cottages in SMSF
1.1 The audit procedures required to be undertaken in relation to TEAS are as follows:
a. The audit of real estate is the subject of a separate FTB.
b. Where there is an indication that any real estate, may be available/suitable for the residential use of members or associates of members additional audit procedures are to be undertaken.
c. Obtain confirmation from trustees that the property is not being used for residential purposes by members
d. Where the members are using the property for residential purposes, see if it is a permitted use, as described below.
e. Need to consider sole purpose test, in-house assets rules and arms length test.
f. Consider whether an Audit Contravention Report is required if the in house asset rule is being breached.
Holiday Homes in SMSFs — a narrow opportunity
Oct 2008
A member may enjoy an incidental advantage from a holiday home in their SMSF — even though superannuation law generally provides that superannuation money must be used for the "sole purpose" of providing retirement benefits to members. This ClearLaw bulletin focuses on investments in holiday homes acceptable "incidental advantages" under Taxation Ruling SMSFR 2008/2.
Overview
An investment that provides an SMSF member with a direct benefit (other than a retirement benefit) is likely to breach superannuation law. The relevant piece of the law is the "sole purpose" test. However, an exception to that test allows an investment even if it gives a member an "incidental advantage".
The ATO has recently issued a ruling which allows SMSF members to receive a limited benefit from a holiday home owned in the SMSF.
What is the Sole Purpose Test?
Each trustee of an SMSF must ensure that the SMSF is maintained solely for core, or core and ancillary, purposes. This is the Sole Purpose Test. It is found in Subsection 62(1) of the Superannuation Industry (Supervision) Act 1993 (SISA).
The phrase:
"core purpose" relates to providing benefits on, or after, the member retires, turns 65, or dies.
"ancillary purpose" relates to providing for members of SMSFs:
benefits on or after the termination of the member's employment,
employment-related insurance and salary continuance if the member cannot continue in employment for reason of ill-health (whether physical or mental),
some benefits in respect of each other member of the fund on or after a member's death
A SMSF trustee who maintains a SMSF for any other purpose contravenes the Sole Purpose Test. This means that the:
SMSF may lose its complying fund status — which incurs a significant tax penalty; and
trustees may receive civil and criminal penalties.
The Sole Purpose Test is a strict test. It is not a "dominant purpose" or "principal purpose" test. It is a "sole purpose" or exclusive purpose test. The purpose for an investment is determined by an objective judgement on what the SMSF is organised for, and how it achieves that goal. The test is not on the outcome that actually emerges.
Even so, the ATO acknowledges that the sole purpose test is not breached if a member receives an acceptable "incidental advantage".
What is an 'incidental advantage'?
The Commissioner of Taxation recognises that a properly considered and soundly-based investment (such as the purchase and rental of a holiday property) may provide benefits to members or other related persons:
that are "incidental, remote or insignificant"; and
that cannot be described as "core" or "ancillary" purposes (the standard required to meet the Sole Purpose Test).
For an investment that provides incidental advantages to pass the Sole Purpose Test:
the benefit must be incidentally and not purposely provided to a member or other entity; and
the trustees' other activities must demonstrate that the SMSF is being maintained consistently with the Sole Purpose Test.
Conversely, a benefit is not incidental (and will breach the test) if the trustee makes the investment so as to provide that benefit.
The ATO's ruling — SMSFR 2008/2
s rental did not breach sole purpose test
Joanna Mather Superannuation writer
Updated Aug 24, 2018 – 4.07pm, first published at 9.24am
A father was able to lease to his daughter a property owned by his self-managed superannuation fund (SMSF) without breaching the sole purpose test, a court found.
The decision may have profound implications for the leasing of SMSF properties to related parties, an arrangement often considered off limits.
When university student Emma Benson rented a unit part-owned by her father's Benson Family Super Fund, the Australian Tax Office said it was a breach of the sole-purpose test.
"The big-picture objective is to provide a way for younger generations to use their super to co-invest with their parents' super in property, and be able to rent the property," Domacom chief executive Arthur Naoumidis says. Ryan Stuart
In December of last year, the Federal Court agreed.
But the decision has this month been overturned, with a Full Court of the Federal Court finding any benefits derived were "merely incidental".
The sole-purpose test requires super assets to be managed exclusively for the purpose of providing retirement benefits.
Sladen Legal principal Phil Broderick said the court was swayed by the fact the apartment was leased to Ms Benson at an arm's length price.
"The court found there was no financial or other incidental benefit to the daughter," he said.
"Therefore, the SMSF was being run for the sole purpose of providing retirement or death benefits."
Mr Broderick said the ATO might have to rethink its approach.
'Setback to ATO'
"The reason this is significant is that it shows that related-party dealings, in themselves, will not breach the sole-purpose test, especially if they are arm's length terms," he said.
"I think this will be a setback to the ATO as they have increasingly taken an expansive view of the sole-purpose test for SMSFs that have related-party dealings, even where those related-party dealings are on an arm's length basis."
The ATO has not yet decided whether to appeal. And a spokesman had this warning about interpreting the decision too liberally: "Any question of whether a SMSF is maintained in accordance with the sole-purpose test will turn on the particular facts and circumstances of that SMSF and its investments."
Christopher Benson is the Victorian state manager of ASX-listed Domacom, a fractional property investment platform. In fractional property investment, an investor buys a portion of a property and is entitled to a share of the rent it earns.
In 2015, the Benson SMSF became a part-owner of an apartment in Burwood through a sub-fund of the wider Domacom Fund. Ms Benson became the property's third tenant.
While there was no breach of the sole purpose test, the judges did find the SMSF in breach of the in-house asset test.
Domacom chief executive Arthur Naoumidis said the in-house asset breach could be easily remedied by a change in documentation.
He said the sole purpose test finding was a game-changer for Baby Boomers wanting to help their children into property.
The idea is that both parties would tap their super to co-invest in property.
The junior party would use their growing super balance to progressively acquire equity from his or her parents.
"The big-picture objective is to provide a way for younger generations to use their super to co-invest with their parents in property, and be able to rent the property," Mr Naoumidis said.
"Now that the court has ruled that our investment sub-fund does not breach the sole purpose test, we cannot for the life of us see why the ATO will continue fighting this."
Collateral purpose
DBA Lawyers director Daniel Butler said the decision was a "major win for SMSFs and taxpayers".
It confirmed that arrangements on arm's length terms typically did not contravene the sole-purpose test, he said.
It also clarified that the word "benefit" in the sole-purpose test referred to a financial benefit rather than a "current day benefit" such as providing accommodation to a relative.
DBA Lawyers provided some advice about the case to Domacom but did not act for the company.
The judges were persuaded by factors such as the property being acquired and leased to others before Ms Benson's tenancy.
The leasing of the property was also handled by Student Housing Australia, which was unrelated.
"If, however, the lease were not at market rent, then an inference would probably readily be drawn that the fund was being maintained for a collateral purpose, namely to provide discounted accommodation to a relative of a member of the fund, contrary to the sole-purpose test," a judgment published on August 10 says.
Some SMSF trustees see residential property that is in a beachside or rural setting as an opportunity to take advantage of the higher rents from holiday makers who may rent the property on a short-term basis.
While an SMSF fund is not prohibited from owning short-term rentals, the temptation is that the trustees, members and their friends and relatives may stay in the property while it is vacant or reserve it during peak periods. The main argument put forward by the SMSF trustee is usually that the related party has paid an arm’s length rent for the property when it was rented, so it’s generally considered acceptable. This may comply with the arm’s length commercial basis of investment under the Superannuation Industry (Supervision) Act, but it is only one of the rules the fund must satisfy. Each superannuation standard an SMSF is required to comply with is considered independently.
Renting a residential property to a member, trustee or their relatives may result in the value of the property being included in the fund’s in-house assets. As the value of the property is usually greater than 5% of the value of the fund’s total assets, it is likely there will be a breach that could result in a financial penalty being imposed on the trustee. In the case of repeated breaches, the trustee may be disqualified, or the fund may be taxed as a non-complying fund.
If it is decided that the holiday house is to be rented to related parties and their friends at a substantially discounted rate, or at no cost, the danger is that the income of the fund could be taxed as non-arm’s length income due to the non-commercial nature of the arrangement. Recent amendments to the income tax law, which were back dated to 1 July 2018, now take into consideration expenses of such transactions which are non-commercial. This can impact on the income received as well as any capital gains when the property is sold.
One would not ordinarily choose to take on the Commissioner of Taxation without being well and truly prepared for the consequences.
Well, recently, one Mr Benson did precisely that and, to date, despite some initial setbacks, has had a win.
Without going into all the complexities, Mr Benson’s SMSF invested in a trust that owned a student accommodation complex containing a number of flats. The investment entitled his SMSF to the income from a particular flat. After the SMSF acquired the interest, it was decided to lease the flat to his daughter. It seems Mr Benson may have done this intentionally to set up the contest with the Commissioner.
His reason may have been that he wanted to test the limits of, among other things, the Sole Purpose Test* in the context of the Superannuation Industry (Supervision) Act. Mr Benson was also the Manager of the managed investment scheme, DomaCom, which owned the accommodation complex. I suspect there was a marketing opportunity for DomaCom if he obtained the outcome he was seeking.
The Sole Purpose Test is the legislative underpinning of the Government’s overriding policy objectives for superannuation, namely ensuring retirement income for an aging population. There are tax benefits for superannuation investment so the law is structured to ensure those investment decisions are not about providing present day benefits for members. Rather, the sole purpose for which the funds are invested must be members’ retirement incomes.
The Commissioner carries a very big stick for non-compliance with the Test and has stipulated in guidelines issued prior to the case that investments must meet strict standards. There must be exclusivity of purpose, not just a dominant or principal purpose. This does not exclude, however, incidental, remote or insignificant purposes or benefits that might arise besides the sole purpose. So the fact that your current day taxable income (and tax liability) is reduced does not of itself disqualify the investment, so long as it is an incidental, remote or insignificant effect of making a decision to produce retirement income.
The Result
Mr Benson lost his first two rounds. A number of issues were considered in Mr Benson’s case in the Administrative Appeals Tribunal and then in the Federal Court. The single judge in the Federal Court found that Mr Benson’s SMSF had breached the Test by providing accommodation to a relative, namely Mr Benson’s daughter. The decision was also seemingly influenced by an email from Mr Benson that quite bluntly said that he was using the proposed lease to test the related party use of residential property within self-managed superannuation funds.
Having lost these rounds, Mr Benson stuck to his guns and appealed to the Full Court of the Federal Court of Australia. There, the three judges unanimously held that the fact that a related party enjoys the use of an SMSF asset does not in itself mean the Sole Purpose Test has been breached.
In this case the facts established:
The decision to lease was made two years after the asset was acquired
The rent payable, met market expectations
The daughter was a perfectly acceptable tenant and she didn’t receive any benefit — after all she was obliged to pay market rent
The SMSF was in receipt of the same income it would have received had it leased it to another
There was nothing to suggest this was an imprudent transaction
The email, suggesting an ulterior purpose, was sent by Mr Benson in his role at DomaCom and not in his trustee role in his SMSF
Key lessons
Many consider that the outcome of this case is surprising and has pushed back the limits of the Sole Purpose Test. It is yet to be seen whether the ATO will appeal.
But even if the Full Court decision stands, trustees of SMSFs need to be careful. In reality, I don’t think terribly much has changed from prior to Mr Benson’s case (Aussiegolfa Pty Ltd v. Commissioner of Taxation).
The outcome for the following examples would not be affected by the case:
Example 1:
Causing your SMSF to buy a newsagency (or any business) so as to employ yourself or your child may be questionable.
Example 2:
Buying business real property and leasing it to a related entity to conduct a business has been acceptable for many years, but if the rent is a discount to the market, then it may result in a breach of the test. The SMSF will need evidence showing:
the rent is at market value; and
the lease terms are those one would objectively expect in an arms-length transaction.
Example 3:
Buying a holiday apartment which is managed by independent management and rented out to third parties at market rates should meet the Sole Purpose Test.
But what is the position if the member then decides to stay at the property? The ATO suggests that if the member pays the market rates to the management agent then there should not be any breach of the Test. However, reserving one month a year for the family at no cost will cause significant problems.
The take home message is to ensure you are clear that the purpose for your investment decisions are for retirement purposes only.
If you are unsure to the purpose for your investment, we suggest you seek legal advice.
Hadyn Oriti is a Partner with Donovan Oates Hannaford. He has a wealth of experience in Estate Planning and Self-Managed Superannuation Funds.
If you would like to discuss any issues you may have with respect to your Self-Managed Superannuation Fund, please contact Hadyn on 02 6583 0427 or horiti@dohlaw.com.au
*This is a test that ensures a superannuation fund is maintained for the purpose of providing benefits to its members upon their retirement or for beneficiaries if a member dies
Comments