The concept of 'arm's length' is central to a number of self-managed superannuation fund rules. While most trustees know this, many might not be aware of just how many of the rules include this requirement.
The arm's length rule and the sole purpose test
Broadly speaking, any investments by an SMSF trustee must be made and maintained on an arm's length basis ('arm's length rule'). This is not as straightforward as it might seem.
The arm's length rule states that parties to an investment transaction must deal at arm's length. If they do not do so, the terms of the transaction must not favour the non-SMSF party any more than what would reasonably be expected if the parties were unrelated. This broadly suggests that an investment that favours the SMSF may be acceptable. However, for reasons discussed later, this is not always the case.
The second quirk in the arm's length rule is that it says that if an SMSF trustee invests, and subsequently during the term of the investment, the trustee is 'required to deal' with the related party, the SMSF trustee must deal in the same manner as if the parties were at arm's length.
This might suggest that where an SMSF trustee invests, and the entity that it invests in proceeds to deal in a non-arm's length way with other parties, the SMSF trustee may not be contravening the arm's length rule because it is not being 'required to deal' with the other party.
In a legal case, 'Montgomery Wools', an SMSF, bought all the units in a related unit trust. The unit trust essentially allowed its assets to be used to support a family business. The Administrative Appeals Tribunal took the view that because the SMSF only passively allowed the unit trust to operate in this way, the arm's length rule was not contravened. However, the sole-purpose test was contravened. That is, the actions were not caught by the narrower arm's length rule, but they were caught by the sole purpose test.
From a commonsense standpoint this is strange, because the same family is essentially controlling all entities, yet the arm's length test can focus on the SMSF entity alone, ignoring a closely controlled entity.
Indeed nearly all reported contraventions of the sole purpose test arise are non-arm's length dealings.
Tax and non-arm's length dealings
The concept of arm's length also arises in the context of a special kind of income called non-arm's length income. Non-arm's length income loses the usual concessional SMSF tax treatment and is taxed at 47 per cent this income year (45 per cent next year after the expiry of the temporary budget repair levy). Broadly, the relevant rule states that income is considered non-arm's length income if it is derived from a scheme where the parties are dealing as related parties, and the income derived by the SMSF is more than might be expected had the parties dealt at arm's length.
Non-arm's length income therefore means that an SMSF is not able to invest in a way that favours the SMSF. Overall the rules aim to make SMSFs invest in a way that means their income is neither too much, nor too little.
Non-geared unit trusts and companies
An SMSF is broadly able to invest in a unit trust or company that is controlled within the family group if that entity falls within the definition of a 'non‑geared' unit trust or company.
Unit trusts and companies of this type have many restrictions and cannot borrow money, loan money, etc. They must deal in an arm's length way with any party. If any transaction is not done on an arm's length basis, it will mean that the unit trust or company is considered an in-house asset. The provision is phrased to capture all non‑arm's length transactions, no matter which party is favoured. Once this occurs, the unit trust or company will always be considered an in-house asset for that SMSF even if the mistake is rectified.