Expert SMSF insights
COVID-19 and the impact on in-house assets
By Nick Ali
As I sit here in government-imposed lockdown, pondering where to put the 3.5 tons of panic-bought firewood being dumped in my driveway (perhaps I should store it under the house next to the 5,000 rolls of panic-bought toilet paper?), my mind turns to the last severe downturn that impacted asset valuations in self-managed funds – the Global Financial Crisis (GFC).
During that tumultuous period, the SMSF industry raised concerns with the Australian Taxation Office (ATO) that there may be potential problems complying with the in-house assets rules in a market where valuations are fluctuating widely. The concern was the changing market values would cause some trustees to breach the 5% rule that applies to in-house assets in an SMSF.
As a rule, SMSFs are prohibited from acquiring assets from related parties. The notable exclusions to this strict rule are listed securities, units in a widely held unit trust (like a managed fund), business real property, certain related unit trusts and in-house assets.
A basic definition of an in-house asset is one of the following:
- a loan to or investment in a related party of the fund;
- an investment in a related trust of the fund; or
- an asset subject to a lease arrangement between the trustee and a related party of the fund.
In-house assets are limited to no more than 5% of the fund’s total assets. The test is at 30 June in a financial year.
If this limit is breached, the trustees are required to prepare a written plan to dispose of one or more of the in-house assets to reduce the overall in-house asset value back to the 5% limit by the end of the next financial year.
Breaches of the in-house asset rules may result in the ATO issuing the trustees with a penalty of up to $12,600 per trustee. This penalty must be paid personally (the SMSF cannot reimburse the trustees).
For more serious breaches, the ATO may issue the SMSF with a notice of non-compliance, which can have significant taxation consequences.
During the GFC, the ATO provided trustees with a 1-year grace period where they exceeded the 5% limit on in-house assets; to allow asset prices to recover, rather than requiring assets be disposed. So long as the trustees prepared a written plan, the ATO were unlikely to take remedial action if the plan was not executed by the end of the next financial year because the market recovered.
So, will the ATO show the same discretion during the COVID-19 global pandemic? Thankfully, the ATO announced it will not undertake compliance activity if the rectification plan was unable to be executed because the market has not recovered, or it was unnecessary to implement the plan as the market had recovered.
To illustrate the point, let’s take the example of Frank. Frank has an SMSF worth $1.1m. His fund has lent $50,000 to his related company, so it can purchase a 3D printer. The loan is supported by a Loan Agreement with commercial terms and conditions.
As the loan is on arm’s length terms and is within the 5% in-house asset threshold ($50,000/$1,100,000 = 4.55%), it complies with the rules. However, due to COVID-19 and resulting economic turmoil, the other assets in Frank’s SMSF drop dramatically; to the point where his SMSF, as at 30 June 2020, is worth $700,000, The outstanding loan balance is worth $49,000 at that date, so it breaches the 5% in-house asset test limit ($49,000/$700,000 = 7%).
The trustees of Frank’s fund would need to put in place a plan to get the in-house asset within the 5% limit by 30 June the next financial year (2021). If the ATO shows similar discretion as it did during the GFC, if Frank’s fund assets recover somewhat, so they are $920,000 by 30 June 2021 and the outstanding loan balance is, say, $45,000 ($45,000/$920,000 = 4.89%), then Frank’s fund does not need to take any action. The fact Frank’s fund had a plan to dispose of in-house assets, but did not act on it, would not incur the wrath of the ATO.
However, it is quite conceivable that recovery will be slow, given the extreme economic impact government measures taken in tackling the virus, have caused. What if Frank’s fund, as at 30 June 2021, is only worth $800,000, due to a prolonged recession? It would still be required to put together a plan to rectify the in-house asset breach by the end of 2021 FY, but the ATO’s announcement means they will not undertake compliance activity if the rectification plan was not implemented because the market had not recovered by 30 June 2021.
What legislative provisions are the ATO using to enact this in-house asset compliance relief? Can they even do this?
The ATO can ignore the contravention under section 42A(5) of the SIS Act (1993), after considering the taxation consequences that would arise if the compliance status of the fund was removed. As mentioned above, for the 2008/09 financial year, in response to the global financial crisis, the ATO agreed to assist funds by not taking any action where the fund had exceeded the 5% limit on 30 June 2009 and rather than disposing of assets to allow the fund to meet the 5% limit, the fund resolved to wait for markets to recover to return the fund’s in-house assets to below the 5% level by 30 June 2010. However, where the fund continued to be in breach of the in-house asset level of 5% by 30 June 2010 the ATO technically could have acted against the fund.
When asked this very question in 2010, the ATO did note a common-sense approach would be taken, on a case by case basis, when considering whether the discretion in subsection 42A(5) should be applied. It was noted that it was cases where funds exceeded the in-house assets threshold by substantial amounts, and the trustees have failed to take any steps to address the issue, that remained the principal concern for the ATO. It now appears a similar common-sense approach will be applied during the current global pandemic.
Such discretion is indeed welcome relief to beleaguered Australians who are coming to terms with the greatest crisis our nation – indeed the world – has faced since World War 2.
In these unprecedented times, the words of my little sister come to mind, “Drink plenty of water, take lots of Vitamin C and don’t stress!”
Sage words indeed.
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