Expert SMSF insights
SMSFs with impaired tenants – a new commercial norm
By Peter Burgess
The financial impact of the drastic, but necessary, Government actions to flatten the COVID-19 infection rate curve, are really starting to bite.
In recent times the SuperConcepts technical team has been inundated with calls and emails from advice providers with concerned SMSF trustees who, like many, have a commercial property in their SMSF with a related party tenant who is now unable to pay their rent.
One of the unique and undisputed benefits of an SMSF is the ability of small business owners to lease a business premise from their SMSF. But with this comes the requirement to ensure all lease payments are on commercial arm’s length terms. And that’s where things right now are becoming increasingly difficult and untenable for a growing number of SMSFs caught up in the economic turmoil caused by the Coronavirus pandemic.
Already we have heard many unfortunate and heart-breaking cases of small businesses being forced to shut their doors and commercial tenants unable to pay their rent and mortgage repayments. Whatever cash flow they do have is being used to keep as many of their staff employed on some basis and to keep their business afloat. In these circumstances paying lease payments to their SMSF is understandably a secondary consideration.
Can SMSFs give Rent Relief?
So, where does that leave their SMSF? Is it ok to simply forgive those lease payments and offer the related party tenant a rent-free period or some other form of financial relief? Or do such arrangements constitute a breach of the rule which requires all fund assets to be made and maintain on an arms-length basis?
Technically, as long as the trustees can demonstrate the arrangement is on arm’s length commercial terms then it doesn’t matter what those terms are. But what constitutes a commercial arm’s length basis in the current environment? The last global pandemic like this was the Spanish Flu back in 1918, so right now there is no modern-day precedent, or complete set of rules, to guide us.
With the list of industries impacted by compulsory Government shutdowns seemingly increasing by the day, the evidence of rent-free periods and rent assistance packages is fast becoming the norm throughout the entire community. So you would think we are not that far away from having a complete set of rules, or acceptable understanding, which SMSF trustees can use to demonstrate their decision to offer a related party tenant some rent relief that is consistent with a commercial arm’s length arrangement.
What happens if an SMSF can't repay its LRBA?
It’s a similar situation for SMSFs which have borrowed funds using a related party Limited Recourse Borrowing Arrangement (LRBA) to acquire a business premise which is leased to a related party.
If the fund is no longer receiving lease payments from the related party and is therefore unable to service the related party loan at a rate, and in a manner, consistent with the ATO’s safe harbour parameters, does this mean the sale proceeds will be taxed as non-arm’s length income if the fund is forced to sell the business premise?
Again, it depends on whether the SMSF trustees can demonstrate the related party lender’s decision to waive or reduce the loan repayments is consistent with a commercial arm’s length arrangement.
Practical steps for an SMSF to demonstrate arms-length terms
But to move this conversation along, and while we wait to be informed by the commercial norms of rent-free periods, loan repayment waivers and the like, there are some practical steps SMSF trustees can take to help demonstrate arrangements they have with related party tenants and/or related party lenders are on commercial arm’s length terms:
1. The first thing to do is check your documentation (i.e. your lease agreements and/or loan documents). This will give you a better idea of the extent to which the existing arrangement can be altered. A decently drafted document will have agreement variation provisions and probably even Force Majeure clauses.
A Force Majeure clause (French for "superior force") is a contract provision that allows a party to suspend or terminate the performance of its obligations when certain circumstances beyond their control arise, making performance inadvisable, commercially impracticable, illegal, or impossible. The process would be instigated by the tenant (related party or not) outlining the reason why the rental obligations cannot be met (e.g. government enforced social distancing).
2. The landlord (the SMSF trustees) then needs to consider the ramifications of the request including what the alternatives may be. In normal circumstances one such consideration would be the eviction and replacement of the tenant. But if the circumstances would preclude either finding a new tenant or the same issues being faced by a new prospective tenant, then eviction may not be a prudent step or in the SMSF’s best interest.
3. The trustees then need to determine the way they will vary the agreement based on these factors and then propose an alternative arrangement. This may take many forms including rental waiver, reduction or deferral as well as specifying a period or trigger for the termination of the relief (e.g. the lifting of crowd restrictions). This outcome should be documented and accepted by both the trustees and the tenant.
Where there is a lender involved in the transaction, such as a rental property purchased via an LRBA, then the SMSF trustee, as borrower, would need to approach the lender for application of concessions under the loan agreement in a similar way.
We may see concessions announced to deal with situations where an SMSF or a related entity has been impaired due to the economic turmoil caused by the Coronavirus pandemic. And given the current environment, providing financial relief is an inevitable commercial reality. But while we wait for further announcements and commercial norms to be established, documenting relief arrangements with related parties and providing a commercial justification with clear reasoning as to why such an arrangement is in the best interest of the SMSF, is a good start.
Stay ahead of the game. Know the best strategies and how the latest regulatory changes affect your SMSF compliance. Sign up for SMSF news and insights from Australia’s top experts. A must for advisers and accountants.
Receive regular insights from our experts
Please complete all fields