SMSFs are prohibited from investing in related party investments however, there are some exceptions to this rule.  In this article, we’ll focus on the exceptions that apply to related unit trusts, as well as pre-99 trusts, and also discuss the potentially significant consequences of breaching these rules.

Related unit trusts fall under the in-house asset (IHA) definition meaning an SMSF can invest in that trust however, it needs to comply with the 5% limit on total IHAs at the end of each financial year.  This can be difficult to meet for investments in related unit trusts, as they will often exceed that limit.  There are however, three investments that are specifically excluded from the IHA rules:

• Business real property (BRP) leased between the fund and a related party;
• Investments in related non-geared unit trusts or companies; and
• Investments entered into before 11 August 1999.

To qualify as a related unit trust that is exempt from the IHA rules, the regulatory requirements contained in Division 13.22C and 13.22D of the SIS Regulations must always be met.  It’s important to stress that they must be met at all times during the year and not just at certain points.  To summarise, the main criteria are that the trust must not:

• Have any borrowings or charges on the trust’s assets;
• Lease any property to a related party unless it is business real property;
• Invest in another entity (e.g. shares in a listed company); or
• Conduct a business.

Having a related unit trust that meets these requirements, provides flexibility for an SMSF to invest in assets, such as property, that it may not have previously been able to by having multiple unit holders.  It can also minimise risk to the SMSF by only holding a portion of the investment in the related unit trust.

Unit trusts established prior to 11 August 1999 were considered ‘gold’ as they provided the ability for the trust, and by extension the SMSF, to borrow to acquire assets.  Prior to the simpler super rules being implemented from 1 July 2009, SMSFs were strictly prohibited from borrowing to purchase investments.  This has now changed as they can use a limited recourse borrowing arrangement however, this may not be suitable for all SMSFs.  Therefore, it might still be worthwhile maintaining an existing pre-99 trust.  There are restrictions though, on what can be done in the pre-99 trust to continue to be excluded from the IHA rules.  From 1 July 2009, these trusts were no longer be able to:

• Reinvest earnings from the trust;
• Pay up partly paid units; or
• Accept any additional investments to that trust.

If the SMSF reinvested earnings or made additional investments in the pre-99 trust, the additional investment would be treated as an IHA and count towards the 5% limit.  

Also, a common example we’ve come across is where a pre-99 trust has a loan but also limited cash reserves.  After making the required loan repayments, the trust does not have enough cash to pay out the SMSFs entitlement thus, creating a beneficiary loan account.  If this continues each year, this loan account can grow significantly, potentially breaching the IHA rules, as well as the arm’s length rules and sole purpose test.

Assuming then that the IHA limit is breached, the trustees of the SMSF are required to prepare and implement a written plan to reduce the market value of all IHAs in the SMSF to 5% or below, before the end of the next financial year.

Where a related unit trust triggers an event in reg 13.22D, such as unpaid distributions meeting the ATOs definition of a loan, it will also be permanently tainted and no longer exempt from the IHA rules.  Investments in related unit trusts or pre-99 trusts that are no longer exempt from the IHA rules, can have significant consequences for an SMSF, as they typically only have a few options to rectify the issue:

1. Divest themselves of the units at market value, potentially triggering capital gains;
2. Set-up a new ‘complying’ trust and transfer the investment(s) across, potentially triggering capital gains and possibly stamp duty; or
3. Sell the trust assets and wind it up.

Therefore, it’s imperative these trusts are reviewed regularly as it’s quite easy to unknowingly breach these rules.  This can result in potentially significant action that needs to be taken, to ensure the SMSF continues to be compliant.