SMSF Compliance Guide: Using Related Party Trusts

Exceptions to the In-House Asset Rules

SMSFs are generally prohibited from investing in related party investments. However, there are specific exceptions that allow strategic use of related unit trusts and “pre-99” SMSF unit trusts.

This guide will focus on the conditions, risks and real-world applications of those exceptions for accountants and advisers supporting their SMSF clients.

Adviser Note: These exceptions can unlock significant flexibility in client structuring, but they carry a high audit risk if not reviewed regularly.

Understanding SMSF In-House Asset Rules

Investments in related unit trusts fall under the in-house asset (IHA) rules. The SIS Act allows an SMSF to invest in a related trust, but limits this to 5% of the total market value of the fund’s assets at 30 June each financial year (SIS Act s71).

This cap can be difficult to manage, as investments in related unit trusts often involve property or multiple related parties.

Adviser Insight: Always monitor valuations and changes to fund asset composition near 30 June. This is a frequent area of accidental non-compliance.

What Counts as an In-House Asset?

The ATO defines IHAs as:

• A loan to, or an investment in, a related party of the SMSF
• Assets leased to a related party

Exceptions to the IHA rules:

1. Business real property (BRP) leased between the SMSF and a related party
2. Investments in compliant non-geared unit trusts or companies (per SIS Regs 13.22)
3. Investments entered into before 11 August 1999

To remain exempt, a related unit trust must continuously satisfy these conditions throughout the financial year.

Adviser Tip: Exception eligibility must be documented and reviewed yearly. Include this in your standard EOFY checklist for all SMSF clients with related party exposure.

Key Compliance Criteria Under SIS Reg 13.22C and 13.22D

To qualify for exemption, the trust must not:

• Have any borrowings or security interests (charges) over its assets
• Lease property to a related party, unless it is business real property
• Invest in another entity (such as listed shares or units in other trusts)
• Carry on a business of any kind

These conditions must be met at all times and not just at year-end.

Adviser Warning: A single breach, no matter how small, can taint the trust permanently. Ensure clients understand the implications before committing to a related unit trust strategy.

Pre-1999 SMSF Unit Trusts: Strategic Legacy Structures

Prior to the introduction of limited recourse borrowing arrangements (LRBAs), SMSFs were only permitted to borrow using pre-99-unit trusts.

Pre-99 trusts may still offer strategic benefits however, there are important restrictions.

Restrictions for Pre-99 Trusts (Post-1 July 2009)

Since the 2009 changes, these trusts are no longer allowed to:

• Reinvest earnings
• Pay up partly paid units
• Accept any additional contributions

If any of these restrictions are breached, those amounts will be treated as in-house assets and may result in a breach of the 5% IHA threshold.

Adviser Tip: When taking on a new client with a pre-99 trust, request the original trust deed, prior financials, and ATO correspondence – historical issues often get missed.

Client Scenario: Pre-99 Trust under Financial Hardship

A pre-99 SMSF trust owns a property and services a loan. Rental income covers the required loan repayments however, there is not enough cash to pay distributions to the SMSF. To record the unpaid entitlements, a beneficiary loan account is created in the trust.

Compliance Risks:

• The unpaid entitlement may be treated as a loan to a related party
• Breach of SIS Reg 13.22D
• Trust becomes permanently tainted (no-longer IHA exempt)

Adviser Insight: If a client is accruing unpaid distributions, this must be flagged immediately. Debt recording can inadvertently trigger a compliance breach.

What Happens if the 5% IHA Limit is Breached?

Trustees must take corrective action:

• Prepare and implement a written plan to reduce IHAs to 5% or less
• Ensure this is achieved before the end of the next financial year

Risk: If the above is not completed, the fund may become non-compliant and receive ATO penalties.

Adviser Action: Add a compliance buffer – track IHA limits at ~4% and advise clients of trigger points before the June deadline.

What is a Permanently Tainted Unit Trust?

If a related unit trust breaches the conditions in SIS Reg 13.22D, such as allowing unpaid entitlements or reinvestment, it becomes permanently tainted.

Consequence: the trust is no longer exempt from IHA rules and the SMSF must either:

1. Sell the units (which may trigger CGT or liquidity issues)
2. Restructure via a new trust and transfer the assets (potential CGT or stamp duty)
3. Sell the trust assets and wind up

Adviser Warning: Once a trust is tainted, the recovery path is limited and often costly. Proactive compliance is far cheaper than reactive fixes.

When to Use These Structures

13.22 Trusts:

• An SMSF wants co-invest with a related party to purchase BRP
• Confident that long-term compliance can be maintained

Pre-99 Trusts:

• It already exists and is compliant
• Client wants to avoid CGT from selling current trust assets
• Sufficient ongoing liquidity to avoid future capital injection

Consider other structures if:

• There are plans to further develop or gear the asset
• A loan is or may be required
• Client requires flexibility with paying distributions or managing future capital requirements

Adviser Prompt: Review strategic intent before recommending or maintaining these structures. If flexibility or capital needs are high, consider alternatives such as LRBAs or interposed entities.

Client Discussion: What Structure is Best

• “For the existing trust, have you received regular distributions or have they been accrued?”
• “Do you think the trust may need to reinvest earnings or require capital raising in the future?”
• “Does the trust lease a property to your business or another related entity?”

Adviser Tip: These client questions double as a compliance check – document answers and revisit annually.

SMSF Related Unit Trust Review Checklist

• Does the trust continue to meet all 13.22C/D requirements?
• Are there any loans or charges over the trust’s assets?
• Is the property leased to a related party and is it BRP?
• Has the trust invested in other entities?
• Is the trust carrying on a business?
• Are there unpaid distributions being recorded as loans to the SMSF?
• For a pre-99 trust: Has it received contributions or is it reinvesting income?

Adviser Action: Integrate this checklist into your annual SMSF review template. It helps flag risks before they escalate into breaches.

Final Thought

Related unit trusts and pre-99 SMSF trusts offer flexibility and strategic opportunities, but they come with strict rules and serious compliance risks.

Minor missteps can occur easily, potentially leading to breaches and permanent compliance issues. Regular review and structure management are essential for maintaining compliance. SMSF rules on collectables present similar compliance challenges.

Need Help with Related Unit Trust Compliance?

At SMSF Engine, we support accountants and advisers with reviewing trust structures, IHA rules and maintaining fund compliance. Our team provide practical strategies you can rely on.

Adviser Offer: Book a trust compliance review with SMSF Engine to pre-empt issues before audit season.