While many of the scenarios I have previously written about are somewhat unusual and rarely cross the desk of your average adviser, the issues that I cover in this article will, unfortunately, be far more familiar: issues relating to business property held in an SMSF that is leased to a related-party business.
Such scenarios are quite common, and the rules are well known for the most part. As such, many of you may be puzzled as to what issues there could be that would be worthy of further discussion.
Most professionals would also agree, however, that in recent times the ATO has significantly increased its focus on any and all related-party dealings with SMSFs, including those involving related-party tenants.
As a result accountants and SMSF auditors are increasingly applying additional scrutiny to the dealings between SMSF and related-party tenants — many that may have been in existence for years or even decades. Failure to behave on a commercial and arm’s length basis could lead to a breach under a range of provisions, including the arm’s length rules, sole purpose test, NALI and/or the in-house asset rules.
Such breaches are no joke and yet can be easily avoided by applying greater attention to the legal documentation in place, primarily the lease between the two parties.
With this in mind I encourage my SMSF colleagues to roll their sleeves up, grab a stiff drink and prepare to wade into the typically voluminous, overly legalese, and incredibly dull tome of your SMSF clients’ commercial leases. Below are the main questions you’ll need to address.
- Does a written and signed lease even exist?
When reviewing a SMSF for the first time, we are constantly surprised at how many SMSF landlords simply do not have a signed, formal lease in place with their related-party tenant.
Whilst the rent being paid may be considered reasonable after analysis, the lack of a written lease creates a sense of casualness that undermines the argument that the parties are indeed behaving at arm’s length. Very few commercial landlords would be willing to lease their premises on a casual or a monthly basis unless there was a solid reason
Such reasons might be that the related-party tenant was in the process of moving somewhere else or that the property was to be renovated or redeveloped in the short term, and as a result, a casual leave may well be justified. However, the risk of failing the arm’s length rules is heightened if the absence of a formal lease has been a reality for many years.
Equally common as having no lease is where there was a written lease at some point in the past, but it has expired — often years or even decades ago, and simply been forgotten about. Again, this could create a perception of overly favourable treatment from the SMSF landlord as this scenario is highly unlikely to occur in a normal arm’s length tenant-landlord relationship.
- Is the lease/rental amount reasonable and at a market rate?
This is one requirement that most trustees and their professional advisors have been acutely aware of and attempted to satisfy by applying the rental yield against the market value and testing it against other similar properties. Unfortunately, we do not believe that this will be enough in the future.
An alternative could involve comparative analysis using documented rental values of similar properties. However, the gold standard is obtaining an actual appraisal from a qualified professional. Such an appraisal should also be done regularly.
- Should the SMSF landlord be increasing the rent regularly, and if so, how (e.g. CPI versus market increase)?
One of the main blind spots that we are seeing is that related-party tenants fail to apply annual rental increases that are clearly outlined in their initial lease documentation. Anecdotally this seems to be more just forgetfulness rather than any sort of mischief, and often the tenant is more than willing to pay the additional amount as it often leads to a beneficial tax result.
However, failure to adjust the rent again raises a shadow over the arm’s length nature of the tenancy. In some cases, the “under-payment” of rent across multiple years can result in a hefty debt owed by the related-party tenant to the fund, creating potential in-house loan problems. A related question is how the rent is to be increased.
In most cases, it is a simple CPI or percentage (e.g. 3 per cent), but occasionally, it requires a formal market appraisal to be done. One of the most egregious examples we’ve seen required the parties to adjust the rent to market every 30 June with the added specification to obtain a formal valuation to effect this. Needless to say, this was not happening and indeed was a surprise to the trustees and accountant.
- Who pays the outgoings?
The typical commercial lease will specifically address who is responsible for the payment of rates, land tax, water, etc and, in many cases, the tenant will be the responsible party. In this scenario, they will usually be responsible for all of these outgoings, but occasionally, they will just need to cover part.
Much like the annual rental increase discussed above, this seems to be somewhat of a blind spot with trustees and their advisers, and again, it tends to be a case of not being aware of this rather than any mischief. Just like forgetting rental increases can lead to a potentially serious loan problem, the accumulation of expenses not paid for by a related-party tenant can result in a large debt that is owed by the related party to the SMSF. In some cases, this amount will exceed the 5 per cent in-house asset limit threshold resulting in a breach.
- Should there be a bond under the lease?
Many arm’s-length commercial leases require a bond from their tenants; however this is not universal and varies from tenancy to tenancy.
As such, the absence of any provisions relating to bonds in a related-party lease is not inherently problematic. However, if the tenant is supposed to be providing the SMSF landlord with a bond under the signed lease, failure to do so will again create unnecessary compliance problems.
Typically the dollar value of any potential rental bond may not be material to the financial statements and may not reach the reportable threshold for a compliance breach, but it does feed into a perception that the parties are not transacting with each other on a commercial basis.
The inclusion of commercial property within an SMSF’s investment mix can be a significant boon, providing stable returns and solid long-term growth well suited to the future retirement goals of the members. However, the involvement of related-party tenants adds another level of compliance risk that needs to be acknowledged and considered.
Fortunately, in the vast majority of cases, this risk can be mitigated when the SMSF trustee and their advisors are well versed in the requirements under the commercial lease and take proactive steps to not trip over their own legal documents.