Auditing business real property rented to a related party

One key advantage of using an SMSF instead of other superannuation vehicles, is that a business owner can use an SMSF to acquire property from which to run their business.  

When I first started auditing SMSFs over 20 years ago and came across such scenarios, it was rare that find the existence of a 'normal' lease agreement.  Instead, a one-page agreement was common, and, in many cases, the agreement was not even documented. Trustees certainly had a real reluctance to spend money documenting an arrangement with themselves.

Whilst the reluctance to spend the money remains, trustees and their advisors now generally accept the need for stronger documentation where a commercial property is leased to a related party.  However, in many instances trustees are still not doing enough to protect themselves from potentially adverse compliance and tax outcomes.

It's important that trustees who own and rent business real property to a related party hold that tenant to the same standards that they would an arm's length tenant.  It should not be seen as a free-ride where lax practices are acceptable.

When auditing an SMSF that owns property rented to a related party, we will test the arrangements to assess whether there have been any compliance breaches of the following:

       Section 109 - investments must be made and maintained on an arm's length basis

       Section 62 - sole purpose test

Further, the ATO has made it clear to SMSF auditors that as part of their financial audit, they should be assessing transactions to determine whether there is potentially undisclosed non-arm's length income (NALI) tax liabilities.  In assessing this, we need to consider both whether the income is excessive, and/or whether the expenses in relation to the property are less than they would be in an arm's length arrangement.

So with the above in mind, what specifically is important to the auditor?

When a lease arrangement between SMSF and related party commences

• The trustee should obtain an independent expert opinion of the market value of the annual rental.  This should include a contemplation of whether a rent-free period and additional charges for car parks are appropriate.
• A commercial lease agreement needs to be prepared, setting out the terms and conditions of the arrangement.
• Details of the outgoings should be documented within the agreement with these marked to market.

During the lease term

• The trustee doesn't have to annually justify the commerciality of the lease arrangement to the SMSF auditor.  For example, if the parties have entered into a 5-year agreement, the trustee wouldn't have to obtain a rental assessment until such time as the lease amount needs to be re-negotiated.
• The trustee has to ensure the parties are adhering to the terms of the lease agreement.  This would include that the correct rental amount is being paid, at the correct time.  Consistently short-paying or late-paying rental is not an arm's length dealing. 
• In good faith alterations to the terms of the agreement during the lease term could be contemplated.  The ATO has confirmed this to be a commercial approach during 2020 where the COVID pandemic caused a significant disruption to Australian businesses.  However, it is important that variations are justifiable and documented.

An example of an arrangement not being on arm's length is where an SMSF trustee sought a property valuation and because of an increased valuation, decided to increase the rental to the related party tenant mid-way through the term of the lease agreement.  When this came to audit, we asked for the commercial reason why the tenant would agree to this?  If there is no commercial justification for this, the trustee risks all the rental income being treated as NALI.

What about properties owned indirectly via a trust?

It is our opinion that the arm's length requirements apply equally to property held via a trust which is rented to an entity associated with the members of the fund.  Whilst section 109 is not applied to the transactions of the trust, section 62 could be applied if the SMSF trustee maintains an investment in an entity that is prioritising the interests of the associated business, over those of its unitholders.

Additionally, the NALI rules would apply if the income from the trust distribution is greater than the amount which would have been delivered if all parties were dealing with each other at arm's length.

It should be noted an arm's length assessment should be applied to both related parties and unrelated parties of an SMSF.  Take for example, a unit trust owned equally by three unrelated SMSFs which is not a related party of each SMSF.  If the three parties resolve to have the business pay a higher than market rental to increase the deduction in a profitable business, and therefore transfer the income through the unit trust to the 3 SMSF's where the income is taxed at the lower rate of 15%, then NALI could obviously still apply.

Conclusion

We believe related party property leases will continue to be an area of interest for the ATO, especially as they relate to NALI.  It is therefore important that trustees clearly document the arrangements and keep information on their files to provide to their auditor, or ATO if need be, that justifies the commerciality of the arrangement.

As always, we encourage you to contact the team at Baumgartner Super in Melbourne on 1300 04 SMSF (1300 047 673) with any queries or comments you may have regarding this or any other audit issue.