The trustee of an SMSF is responsible for making sure the fund operates properly. While a trustee can seek others to help with the job such as accountants, financial planners and fund administrators, there’s a few things a trustee can’t do. One of them is to audit their own fund, even if the trustee is qualified to do it. Audits may be a mystery for some trustees as they think they are doing the right thing, but the auditor, as an independent reviewer of the fund, always seems to ask the wrong questions. Let’s have a look at the things an auditor could look for when a fund owns a residential or commercial property so that the next time the auditor asks a question, the trustee will have the right answer.
Real estate investments of an SMSF are one of those assets that are not easy to value as there is no true market value until the property is bought and sold. But when the accounts of the fund are being prepared, when a trustee pays a lump sum or a member commences a pension, then a reasonably accurate value should be obtained. In addition, valuations are required for purposes of the Superannuation Industry (Supervision) Act (SIS Act) for: when a commercial property is acquired from a related party; in-house asset purposes; and to establishing that a transaction has been made on an arm’s length basis.
The ATO says that when preparing SMSF financial reports, an external valuation of real estate is not required each and every year. However, a recent valuation is prudent if the previous value is considered to be materially inaccurate or the value may have changed due to changes in market conditions, a natural disaster or capital improvements. The current economic situation with COVID-19 is certainly one of those situations that may impact the value of the property.
In contrast to the ATO guidelines, auditors have consistently been seeking a greater degree of confidence that the value of the property included in the fund’s accounts satisfies the accounting standards. This may mean a more recent valuation than one that satisfies the ATO requirements.
The valuation of a property, for SMSF purposes, does not require a formal assessment of the property which can be expensive. The valuation may be undertaken by anyone as long as it is based on objective and supportable data. A valuation undertaken by a property valuation service provider, including online services or a real estate agent, is considered to be acceptable. These are usually provided at a minimal cost or free of charge. An exception would be for property that is a significant proportion of the fund’s value or where the real estate has special features and the valuation is likely to be complex. In these cases, a qualified independent valuer should be considered.
When valuing real estate, the assessment may take into consideration:
- the value of similar properties in the area;
- the amount that was paid for the property in an arm's length market;
- independent appraisals;
- whether the property has undergone improvements since it was last valued;
- for commercial properties, net income yields especially in the current situation where rent reductions could impact the value of the property.
Property lease documents
Market valuations of the property is important but so is ensuring the lease documents for the property, especially commercial ‘business real property’ leases are up-to-date and in force. Where an SMSF leases a commercial property to a related-party tenant, it is very important to establish that the lease is on an arm’s length basis for purposes of the tax law for non-arm’s length income and expenses.
In undertaking an audit of the fund, the auditor will review whether the related-party tenant satisfies the terms of the lease, and has made all appropriate rent and outgoings payments, including any concessions such as rent waivers or relief due to COVID-19. There will also be a review to ensure the lease agreement has not expired and the terms of the lease are at arm’s length as per a rental appraisal.
Recent experience with auditors and related-party tenants is that rent adjustments must be up to date and consistent with market rents. In some cases, the related-party tenant has not indexed the rent as required by the lease agreement, or the fund has not sought to seek payment of the rent where it is in arrears. A number of court and tribunal cases have indicated that the trustee of a fund is required to act in accordance with the lease agreement, irrespective of whether the tenant is a related party or at arm’s length.
The economic significance of the COVID-19 pandemic has meant substantial revenue reductions for many individuals and businesses resulting in many tenants, either related or unrelated to the SMSF, are seeking rental relief from landlords. While it is acceptable for landlords to offer relief in relation to the lease and the ATO is taking a reasonable approach to the SMSF’s compliance, the auditor will be looking out for:
- How the tenant is affected – has the business closed its doors as directed by the government or closed due to lack of business/loss of revenue/lack of supplies as they were coming from overseas etc.
- Financial implication to the business- e.g. cash flows implications, is it still a going concern.
- What relief the fund is offering as far as discounts/rent-free periods or deferrals, and why the trustees believe this is appropriate. Trustees may use government guidelines and what is happening on other commercial arrangements which are non-related.
- A set and agreed review period – e.g. two or three months or longer. This continues to change rapidly but a blanket rent-free period for an undetermined period is something that would be questioned.
- Impact period – in view of leases not being impacted by the COVID-19 until late February/March, auditors will be reviewing rentals to ensure they have been paid in accordance with the lease as usual from July 2019 – February 2020.
Loan payment relief
Banks and other financial institutions are offering loan payment relief and, in some situations, an SMSF may also offer loan repayment relief for a loan it has made to a related or unrelated party who has been financially impacted by COVID-19. This may also apply to the fund where it has borrowed from a bank, other financial institution or related party for purposes of a limited recourse borrowing arrangement (LRBA).
Loan payment relief for related-party LRBAs
If the fund has borrowed from a bank or other financial institution, the auditor will be reviewing the terms of the loan repayment relief. As a general rule, the relief would be considered to be on an arm’s length basis. But where a related-party loan has been made to the fund for purposes of an LRBA, it is not as clear cut unless the relief is similar to arm’s length relief arrangements. Any relief should be similar to what is being offered by the banks.
If the relief arrangement is not considered to be on an arm’s length, the auditor may comment on the possible breach of Section 109, which requires the fund to undertake transactions on an arm’s length basis. In some situations where the income and expenses relating to the relief are not considered on an arm’s length basis, then the fund may face issues with the non-arm’s length income rules and be taxed at penalty rates on that income.
As a guide for loan relief, the Australian Banking Association (ABA) recommends that commercial lenders may provide loan repayment relief where:
- interest and principal repayments on the loan can be suspended for up to six months;
- interest will continue to accrue on the loan during the deferral period;
- accrued interest is to be capitalised and form part of the amount to be repaid over the term of the loan;
- the borrower must have been financially impacted by COVID-19;
- the borrower must not terminate a lease or evict a tenant for rent in arrears during the loan deferral period.
The auditor as well as the ATO would usually accept a loan repayment relief arrangement where the trustee can provide evidence the relief is similar or identical to what is offered by for real estate investment loans at the time. The relief should be accepted by the parties and that they can prove they are dealing at arm’s length. Any changes to the loan should be documented, such as capitalisation of interest and the reasons for the change. Any further relief needed due to the continued effects of COVID-19 should be reviewed at the end of the agreed deferral period and remain in line with what the banks are offering at that time.
If an auditor considers the loan relief has not been provided on an arm’s length basis, the auditor may need to report the breach to the ATO by lodging an Audit Contravention Report. The report will include the reason the auditor considers the loan does not meet the arm’s length requirements in the current economic circumstances.
Who owns the property?
Auditors will take an interest to see whether the real estate has actually been acquired by the superannuation fund. The reason is that the title of the property may be in the names of the trustee, which may consist of individuals or a company. Often the auditor will be looking for a ‘declaration of trust’ that the property is held on trust for the superannuation fund.
In the case of properties that are owned by the superannuation fund and other parties, the auditor will also take an interest in the portion of the property that is owned by the fund, whether it is joint ownership or as tenants in common, and whether the property has been mortgaged or encumbered. All of these features can have an impact on the fund meeting its compliance obligations under the SIS Act. For example, if the property has been mortgaged, the fund may be in breach of the rule which prevents placing a charge over a fund asset. The only exception to mortgaging the property is where it forms part of a limited recourse borrowing arrangement, but limits can apply where the property is owned jointly.
SMSF investments in Private Company and Unit Trusts
The valuation of the private company shares or units in a private unit trust that have invested in property, will vary depending on the underlying assets. A company or unit trust that owns commercial or residential property would have shares or units based on the value of the property and expected income. In contrast, if the company or trust operated a business, the value would take the change in turnover and profit to value the investment.
In some cases, the value of the investment may be difficult to ascertain based on asset values and turnover. Where this is the case, the auditor is usually after a reasonable value which could be based on recent share or unit sales, if they are available. This may require contacting the company secretary or trustee of the SMSF to obtain an indicative valuation or copies of financial statements in support of the fund’s holdings. If this is not available or unable to be determined, the auditor may qualify the accounts in the audit report and provide an audit contravention report to the ATO if potential breaches of the SIS legislation have been suspected to have taken place.
What’s the lesson to be learnt?
This could be summed up in a few words- make sure the trustees keep documents of any transactions or changes to agreements, and that they are made on an arm’s length basis. That should keep the auditor happy.
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