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We have a situation with an unrelated unit trust, which purchased a commercial property during the year, with initial unitholdings as follows:
Unrelated Person A Family Trust 26%
Unrelated Person A SMSF 24%
Unrelated Person B Family Trust 26%
Unrelated Person B SMSF 24%
Unrelated Person A SMSF loaned money, on commercial terms, to Unrelated Person B Family Trust, which then used these funds to purchase the 26% units in the unit trust.
Unrelated Person B SMSF loaned money, on commercial terms, to Unrelated Person A Family Trust, which then used these funds to purchase the 26% units in the unit trust.
Unrelated Person A SMSF and Unrelated Person B SMSF, were each issued their 24% initial unit holdings directly.
Shortly after the settlement of the property, Unrelated Person A SMSF then acquired the 26% unit holdings from Unrelated Person A Family Trust and Unrelated Person B SMSF acquired the 26% unit holdings from Unrelated Person B Family Trust. These units were acquired at the same price as the initial investment, therefore no gain. The end result is each SMSF owns 50% of the units in the unit trust.
Our initial concerns were whether this arrangement meets the sole purpose test. When we enquired with the clients accountant as to the purpose of this arrangement and how it meets the sole purpose test, we were advised that the reason for this was to access cheaper lending by having an initial SMSF ownership % less than 50%. Upon further investigation we identified that this is true. Based on this, the only benefit obtained through this arrangement appears to be to the SMSF, through cheaper lending.
Could we please get your thoughts on this in relation to the sole purpose test and any other issues that may be relevant.
Thank you
Thank you, Peter, for raising an excellent question.
The sole purpose test in section 62 prohibits trustees from maintaining an SMSF for purposes other than for the provision of benefits specified in subsection 62(1). The core purposes specified in that subsection essentially relate to providing retirement or death benefits for, or in relation to, SMSF members.
The ATO has released SMSFR 2008/2, The application of the sole purpose test in section 62 of the Superannuation Industry (Supervision) Act 1993 to the provision of benefits other than retirement, employment termination or death benefits.
The concern with the investment you have described, undertaken by Person A SMSF and Person B SMSF, is whether it was undertaken for a reason other than for providing benefits that are allowed for under the sole purpose test.
In many of the examples within SMSFR 2008/2, where the ATO concludes there is a breach of the sole purpose test, a member of an SMSF (or a related party of a member of the SMSF) obtains a financial benefit as a result of an investment decision made by the trustee of the SMSF.
In example 16 in SMSFR 2008/2, an SMSF enters into a limited recourse borrowing arrangement with a related party where the interest rate is 10% above the market interest rate. Unsurprisingly, the ATO concludes "the facts indicate a contravention of the sole purpose test in these circumstances."
It is assumed that the "cheaprer lending" that was made possible in this scenario, was a borrowing made at the level of the unit trust (ultimately owned by Person A SMSF and Person B SMSF, 50%). The unit trust used the borrowed funds and funds subscribed for the issue of units, to acquire the commerical property
There is no suggestion that any related party to either SMSF is receiving a benefit as a consequence of the scenario as described in the question. Indeed, each SMSF is arguably better able to maximise its returns (and therefore better able to provide retirement benefits, etc) by securing a borrowing within the unrelated unit trust at a lower interest rate than what would otherwise be available.
It is also assumed that when Family Trusts sold their units to the SMSFs, that at this point the consideration received was used to pay back the loans the Family Trusts had obtained from the SMSFs, along with any outstanding amount of interest.
That said, the scenario still raises other questions.
For example, are we completely satisfied that Persons A and B are not in any way related to each other?
Even if persons A and B are not relatives, if A and B are carrying on a partnership together, that would be sufficient to make the acquisitions of the units by Person A SMSF from the Person B Family Trust and the acquisition of the units by Person B SMSF from the Person A Family Trust, as being the purchase of assets from a related party. This could be problematic from the perspective of section 65 of the SIS Act. Furthermore, if persons A and B are carrying on a partnership together, that would also be problematic in relation to the loans that the SMSFs made to the respective Family Trusts.
On what basis did the trustees of the SMSFs determine the interest rate on the loans made to the respective Family Trusts? Whilst appreciating these loans were presumably in place for a short period, they should still have been properly documented and commensurate with a genuine arm’s length arrangement.
Also considering section 109 of the SIS Act (broadly, the requirement that acquisitions of investments are made on an arm’s length basis), whilst appreciating that the cross-purchases of units made by the SMSFs occurred “shortly after the settlement of the property”, it would still be advisable to ensure that the value of the property, being the unit trust’s major asset – has not changed since it was acquired by the unit trust under the borrowing arrangement.
It would also be prudent to consider that neither Person A nor Person B is considered to have “sufficient influence” over the unit trust. This could arise, perhaps, in a hypothetical situation where only Person A (or only Person A and/or their relatives) are directors of the trustee of unit trust. In which case, the unit trust could be a related party to the Person A SMSF, even though Person A SMSF does not hold more than 50% of the units. This hypothetical situation would be problematic given the unit trust has borrowings.
Given the unusual nature of this arrangement, it is possible that the trustees of the SMSFs obtained legal advice from an appropriately qualified legal practitioner as to the SIS Act issues associated with this scenario. If any such advice was provided, it would be appropriate for the fund auditor to request to see such advice.
"Shortly after the settlement of the property, Unrelated Person A SMSF then acquired the 26% unit holdings from Unrelated Person A Family Trust and Unrelated Person B SMSF acquired the 26% unit holdings from Unrelated Person B Family Trust."
Sorry this should have said Unrelated Person A SMSF acquired from Unrelated Person B Family Trust and visa versa.