Superannuation was introduced to ensure taxpayers have money set aside for their retirement alongside government support.
In making contributions for your retirement, you have the option of investing your money in a:
(i) registered fund, where the decisions on how your superannuation contributions are invested are made on your behalf by the registered fund’s trustee, depending on the type of risk strategy you choose to adopt; or
(ii) self-managed superannuation fund (SMSF), which allows you to have greater control as to how the money you set aside for retirement is invested.
However, investing your funds in a SMSF does have pros and cons. That is, despite the autonomy that allows you, as a trustee of the SMSF, to choose where to invest super contributions, you are also responsible to ensure the SMSF is compliant. Where you are found to be non-compliant, the Australian Taxation Office (ATO) can take a range of actions against you.
SMSF trustees are responsible for ensuring that the fund is compliant in accordance with superannuation laws and other relevant rules. Where trustees of a SMSF do not comply with these rules, either accidentally or intentionally, the SMSF can be non-compliant and in breach of the relevant laws.
The ATO has released information that throughout the 2023 income year, action has been taken to issue SMSF trustees and their members with $29 million in income tax liabilities, administrative penalties and interest and 753 SMSF trustees were disqualified for breaches of the relevant superannuation laws.
It is paramount that you are aware of your responsibilities as a SMSF trustee. Set out below are what we consider to be common breaches made by SMSF trustees that can attract punitive action from the ATO.
Loan to members
A SMSF is prohibited from lending money from the fund to a member or the relatives of a member. This is regardless of the commerciality of the arrangement or the benefit that it may have to the fund.
However, a SMSF can lend money to a related business, but there are strict rules that must be followed, and failing to do so can lead to penalties of up to $16,500 or other action being taken by the ATO. These amounts cannot be paid from any funds or assets from the SMSF and individual SMSF trustees and directors of corporate trustees of SMSFs are personally liable for any penalties imposed on them.
Investing in high-risk assets
Investing in high-risk assets may not in and of itself be considered a breach of the superannuation laws, but undertaking a risky investment strategy may not align with the investment strategy of the SMSF. Where this is the case, it can be a breach.
SMSF allowing a member to live in a residential property of another member
The “sole purpose test” requires that the SMSF should be for the benefit of the members retirement. Where a member resides in a residential property owned by another member of the SMSF, it is likely to be considered contrary to the “sole purpose test” or being solely for the member’s retirement.
A SMSF member can only live in the residential property owned by the SMSF once the member has retired and the property has been transferred from the SMSF to the member, noting that this will have transfer duty (state tax) implications.
Making an investment in a related entity of the SMSF which exceeds the “5% rule”
Investing in a related entity of the SMSF is not prohibited but it is very limited, requiring many conditions to be satisfied. Failing to comply with any of the rules can lead to a breach.
Under the “5% rule”,, the value of any investments in a related party of the SMSF, a related trust or an asset of the SMSF that is subject to a lease with a related party must not exceed more than 5% of the value of the SMSF. This is difficult to achieve unless your SMSF is reasonably large. For example, for a SMSF that has a total value of $2 million, the total of all investments in related entities cannot exceed $100,000.
Life insurance policy and Buy/Sell Agreements
Where a life insurance policy is used in a Buy/Sell Agreement, the life insurance policy cannot be held under a SMSF. Using a life insurance policy payout for a Buy/Sell Agreement may be attractive and effective proposition, but according to ATO ID 2015/10, it does not comply with the sole purpose test of the SMSF.
There are strict limitations on accessing the funds in your SMSF prior to retirement and payment to finance a Buy/Sell agreement (or Put & Call Option Deeds) can lead to a breach.
Purchasing residential property from a member of the SMSF
A SMSF cannot acquire an asset from a related party of the SMSF, this includes residential property, even if the property is acquired for market value.
An exception to this rule is property that is considered business real property that is acquired by a SMSF from a member for market value.
A breach of this rule can lead to serious consequences for the SMSF trustees.
Borrowing through a SMSF
A SMSF cannot borrow money.
The exception to this rule is a SMSF that makes a borrowing via a valid limited recourse borrowing arrangements (LRBA), assuming the arrangements follow the guidance in ATO ID 2015/18 and PCG 2016/15.
A LRBA has many conditions, and failing to follow any of these conditions can lead to penalties being imposed or other action being taken by the ATO.
Non-arm’s length income and expenses
A SMSF must derive income and incur expenditure on an “arm’s-length” basis.
“Non-arm’s length” income (NALI) is taxed at 45%.
If a SMSF is dealing with another party on a “non-arm’s length” basis, and the income the SMSF receives is more than the market value, or what is expected, that income can be considered NALI.
Alternatively, where a SMSF is dealing with another party on a “non-arm’s length” basis, and the expenses incurred by the super fund is less than the market value or, what is expected, that expenditure will be considered to be “non-arm’s length expenditure” (NALE). To be considered NALE, the expenditure does not need to be a deductible expenditure incurred in the course of gaining or producing assessable income.
Where the NALE has a connection to income of the SMSF, the income will be considered NALI.
An example of the operation of the NALI rules is as follows:
A SMSF does not deal with a party at “arm’s length” and purchases a commercial property for less than market value. The commercial property is then leased by a third party.
There is a sufficient connection between the NALE to the purchase of the commercial property and the rental income derived by the SMSF, so the rental income will be considered NALI and taxed at the highest marginal tax rate.
There will also be a sufficient nexus between the NALE and the capital gain if the commercial property is sold, and so the capital gain will also be NALI and taxed at the highest marginal tax rate.
A breach of any of the above may result in your SMSF not being compliant, losing its concessional tax rate and have its earnings taxed at 45%.
Where a contravention is considered serious, the ATO may disqualify a SMSF trustee if they are no longer considered to be “fit and proper.”
If you have breached the laws, have received a notice of disqualification or a non-compliance order, please contact the Coleman Greig Taxation and Superannuation team.