My fund has bought building materials from a related party, how do I fix it?

Building materials are one of those items your fund can’t buy from a related party. Why can’t I, and if I already have how do I fix it?

Meg Heffron recently wrote an article for the AFR on what someone can legally do to enhance the value of a property owned by their SMSF.

SMSF members often look to do this by doing some renovations, repairs or improvements to their SMSF property.

In that article Meg mentioned that there are two primary risks for SMSFs to avoid when people are looking at doing work on their SMSF property, namely:

1. SMSFs need to pay market rates for goods and services they receive, and
2. There are strict rules around what an SMSF can acquire from a related party

Meg’s article largely focused on the first of those two points because when market rates aren’t paid, income the fund receives from its property investment is classified as “non-arm’s length income” and taxed particularly harshly. Some recent legislative changes mean it’s a hot topic right now.

Luckily, this gives me the perfect opportunity to take a bit of a deeper dive into the second point –the rules about what you can acquire from a related party. Specifically, how these interact with property improvements and what, if anything, can be done if you get it wrong.

First, let’s start with some of the basics.

What does the law tell us?

Super law starts from the position that nothing can be acquired from a related party (and a related party includes people like relatives of fund members as well as certain partners, companies and trusts that the members might be involved in).

There are some specific exceptions – for example, it is possible for an SMSF to acquire listed shares or even commercial property that meets particular requirements and is classified as “business real property” from a related party.

But importantly, the list is both specific and exhaustive. It doesn’t include building materials, small goods, renovation supplies, and other similar items. That means they simply can’t be acquired from a related party.

And it’s important to note that “acquiring” something doesn’t just mean buying it for cash – it could include receiving it for free (which actually creates even more problems – the non arm’s length income issue which was the focus of Meg’s article).

What happens if I have bought building materials from a related party?

Let’s assume the fund paid market rates for the materials – so I am not exploring any issues related to potential non-arm’s length acquisitions.

I am solely focusing on how to fix the illegal acquisition.

At a very high level, the fix for any illegal acquisition (whether it is building materials, unlisted shares or anything else not on “the list” of allowable things) is to dispose of the asset.

Something like unlisted shares can, in most cases, be disposed of relatively easily (albeit with a bit of grumbling). But what about the building materials used for a kitchen renovation in an otherwise perfectly compliant property?

Well, ripping the items out and rebuying them (legally) is certainly an option.

If it is something that can be easily removed and replaced at a reasonable cost (say, an air-conditioning unit) then removing the offending asset(s) and replacing it may well be the best path (as unbelievable as that sounds).

That said, ripping an asset out is not often the most palatable option, or even necessarily a feasible one.

What if the asset acquired cannot be easily replaced? What if it is hugely expensive? What if it is a kitchen refurbishment, something larger, or even something fundamental to the property that cannot be removed?

Largely there are two options from here:

1. Approach the ATO, via a voluntary disclosure, acknowledge that the acquisition happened and ask the ATO to “overlook” the acquisition (and allow the fund to keep the asset), or
2. Sell the entire property

With any attempt to approach the ATO you need to ensure that the acquisition was at arm’s length. There is no point approaching the ATO if it wasn’t. They will be forced to examine the transaction in detail and will be forced to deal with the non-arm’s length nature of the transaction. The SMSF is then locked into potentially disastrous tax outcomes even if the ATO does agree to let the fund keep the asset.

Separately I would also suggest that the size of the acquisition, relative to the property, is an important factor in applying for leniency.

Whilst there is no hard and fast rule around the size of the asset, the nature of asking for leniency lends itself to situations where the asset acquired is not a significant part of the property as a whole (or worse still to the fund as a whole).

If you have exhausted all other options, then you can always fall back on selling the property.

Obviously, selling the property is a very extreme step and one most of us would not want to take willingly but if left with no other option it certainly solves the problem. In fact, it may be the only way to solve the problem in some cases.

That said, quite often we find these kinds of acquisitions are undertaken when a trustee is doing up the property in readiness for a sale. In practice, this means the extreme solution is often the planned route regardless.

Certainly, this is one of those areas where prevention is better than the cure and you are much better off not making an illegal purchase in the first instance than trying to solve it after the fact. If in doubt, contact your fund administrator and ask them the question.

We explore issues like this in our regular (free) webinars for trustees.