Auditing Division 13.3A unit trusts

As SMSF auditors, it is inevitable that every year we will encounter problems in relation to SMSF’s relying on the in-house asset exemption found in Division 13.3A of the SIS Regulations.

Used properly, a Division 13.3A unit trust can provide significant benefits for SMSFs which cannot be obtained from merely investing in property directly. Most notably, a fund can engage with other related funds or entities to invest in larger property acquisitions and property developments which may not be possible with their own resources. However, great care should be taken to ensure compliance with the strict requirements outlined in the legislation. Not only are material contraventions reportable, but the costs of rectification can be substantial and can force trustees to permanently change their investment approach.

Background: in-house asset exceptions

Under sections 82 and 83 of the Superannuation Industry (Supervision) Act 1993 (SISA), in-house assets are limited to a maximum of 5% of a fund’s total assets, both at the time of acquisition and at 30 June. An in-house asset includes:

• an asset leased to a related party
• a loan to, or an investment in, a related party of a fund
• an investment in a related trust of a fund.

Some exceptions to the in-house asset rules include:

• business real property leased to a related party
• investments, loans or ongoing leases entered into before 11 August 1999
• investments in related, non-geared, Division 13.3A trusts or companies.

It is the last exception that is being considered in this article. In coming months we will discuss our audit approach when dealing with pre-11 August 1999 unit trusts.

Regulation 13.22C requirements

Unlike pre-11 August 1999 unit trusts, there are severe restrictions on the investments and transactions a Division 13.3A trust can engage in.  For an SMSF wanting to take advantage of the Division 13.3A exemption, before the SMSF acquires units in the unit trust, the following criteria from regulation 13.22C must be satisfied:  

• The SMSF has less than five members.
• The unit trust does not have a lease with a related party. A lease of business real property (BRP) to a related party is acceptable.
• No outstanding borrowings are held by the unit trust.
• The unit trust’s assets do not include:

      — An interest in any other entity. This includes shares in an unrelated or listed company.
      — A loan to another entity except for a deposit with an authorised deposit taking institution (only approved banks).
      — An asset that is subject to a charge. This means current property title certificates should not show any mortgage or other encumbrances.
      — An asset (excluding cash) that was once owned by a related party. Again, business real property acquired from a related party at market value is an exception to this.

As always, full financial and legal advice which takes into account a fund’s specific circumstances should be sought prior to making any significant investment decision.

Regulation 13.22D requirements

Once an SMSF has invested in an entity which meets the requirements of regulation 13.22C, the requirements outlined in regulation 13.22D become relevant. This regulation lists several trigger events which can’t occur during the trust’s operation in order for the trust to retain the in-house asset exemption. These events are basically either the trust starts to do something that wasn’t allowed under regulation 13.22C or stops doing something that was required.

There are also two additional trigger events which should not occur:

• The unit trust conducts a business.
• The unit trust enters into a transaction which is not on an arms-length basis

Documents needed for audit

To assess compliance with regulations 13.22C and 13.22D and other sections of the SISA, we require:

• Full signed unit trust financials for the year of audit.
• Full trust tax return for the year of audit.
• Documents supporting any properties held within the trust. This includes a yearly signed trustees’ valuation, an external valuation every three years, a new title certificate every 18 months.
• Where a property is leased to a related party, a copy of the signed lease agreement and a rental appraisal from the beginning of the lease term.
• Unit certificates and unit register if it is the first year we audit, or new units have been issued or acquired.

Additionally, we stress the importance of accountants closely reviewing the financial statements of these unit trusts before they are sent to us to ensure compliance.

Consequences of a breach

When an SMSF acquires units in a unit trust and the regulation 13.22C requirements are not met then the units are in-house assets which must be disposed of to decrease the level of in-house assets to below 5%.

If the requirements of regulation 13.22D are not met at some point after an acquisition which met the requirements of regulation 13.22C, the whole trust becomes permanently tainted and the fund can no longer rely on this Division to exclude the investment from being an in-house asset. If this causes the level of in-house assets to rise above 5% (which occurs in most cases), then the in-house asset rules in the SISA have been infringed.  An audit report qualification of Part B and the lodgement of an Auditor Contravention Report will be required where the ATO’s reporting criteria have been met.

It is very important to note that non-compliance with the requirements of regulation 13.22D cannot simply be corrected by restoring the trust to its original position (e.g. full repayment of a loan or disposal of an interest in another entity). As mentioned previously, the whole trust becomes permanently tainted as an in-house asset and the only means of rectification is for the fund to dispose of its units to reduce the in-house asset level to below 5%. A new Division 13.3A unit trust could be established by the related parties, however this is typically a costly and time-consuming process.

Conclusion

Regulations 13.22C and 13.22D are some of the most demanding sections or regulations imposed on SMSF trustees. It is essential they are made fully aware of the ongoing restrictions imposed upon them when they invest in a Division 13.3A unit trust and the consequences of non-compliance. Once trustees understand the requirements, abiding by these rules should not be difficult. An SMSF should then be able to take full advantage of the considerable benefits provided by such trusts for years to come.