The Section 66 Blind Spot

The intention of section 66 SIS is to prevent SMSFs from acquiring assets, other than cash, from related parties unless otherwise exempted. While the rule is still in effect, the ATO's updated approach to reporting contraventions may have inadvertently revealed a section 66 blind spot.

Section 66 acts as a safeguard against trustees from using SMSFs as their personal piggy bank. It also ensures that all transactions are conducted at market value, preventing practices such as asset dumping and illegal early access.

The exceptions within section 66 allow an SMSF to acquire listed shares and business real property from related parties. The acquisition can refer to an asset being purchased in whole or in part by the fund, or to an in-specie transfer of the asset to the fund.

Listed shares have a clear, public market price that trustees cannot manipulate, and business real property brings investment opportunities for small business owners.

The Previous State of Play

Historically, the SMSF industry accepted that rectifying a section 66 breach could only be achieved by selling the asset out of the fund.

In fact, SMSF auditors would typically include this compliance-based advice in their management letters, with advisers following up to ensure the fund returned to compliance.

Where the asset was not sold out of the fund by the following audit, the SMSF auditor would re-report the section 66 breach and provide the same compliance-based advice to the trustees again.

Approach to ACR Reporting

Contravention reporting has shifted in recent times. The ATO accepts that some contraventions occur at a single point in time and cannot be repeated in future years.

Breaches involving sections 66, 103 and 104A should be reported only once through an Auditor Contravention Report (ACR), rather than multiple times for the same issue. This "one breach, one ACR" approach aims to streamline reporting and avoid unnecessary duplication.

It means they are reported in the year they occur, but not in subsequent years unless repeated.

Furthermore, the ATO has advised that breaches of sections 103 and 66 cannot be rectified and should always be reported as unrectified by SMSF auditors.

While sections 103 and 104A of SIS relate to keeping minutes and the ATO Trustee Declaration, a section 66 breach may result in an SMSF blind spot.

The Section 66 Breach Blindspot

The ATO is correct in that there is no way to fix a breach of section 66, as the section does not allow for rectification. It means that, unlike some other compliance breaches, trustees cannot take steps within the SMSF to reverse or remedy the breach.

Section 66, however, allows for imprisonment for a term not exceeding one (1) year upon conviction for the offence. As this type of punishment is typically reserved for the worst illegal early access schemes, outright fraud or theft, it would be rare for a trustee to be imprisoned for a one-off section 66 breach.

Additionally, while section 66 does not impose penalties for a breach, SMSF auditors must still report a section 66 breach where it meets the ATO's reporting criteria (i.e. the value exceeds 5% of fund assets or $30,000).

With the ATO's limited resources and growing pressure, there is a possibility that a risk-based approach will be adopted rather than investigating every section 66 breach, potentially allowing the asset to remain in the fund indefinitely.

A key concern is that, if there is no way to rectify a section 66 breach, what will prevent SMSF trustees who are inclined to act improperly from acquiring illegal assets?

The absence of a rectification mechanism raises questions about whether there are sufficient deterrents in place to stop trustees from using this blind spot to bring prohibited assets into their SMSFs.

It leads to the broader issue of deterrence: without meaningful consequences, will trustees take the risk and attempt to have assets such as residential property, cryptocurrency, or employee shares enter SMSFs, effectively "running the gauntlet" in hopes of avoiding significant repercussions?

While there are limited regulatory consequences for penalising funds for breaches of section 66, trustees should ensure that it is acquired at market value to avoid the application of the NALI rules.

Is it an In-House Asset?

Depending on the asset, a breach of s66 may also be considered an in-house asset of the fund and will be caught by the Part 8 rules.

Acquiring an investment in a related party or a related trust of the fund is an in-house asset and is subject to Part 8. All other assets, unless they are leased to or loaned to a related party, are not.

The difference is that section 66 concerns how the fund acquired the asset, whereas section 71 concerns how the fund deals with related parties on an ongoing basis.

The reason for including in-house assets in this discussion is that some in the industry believe that, for example, if an SMSF acquired residential property from a related party in breach of section 66, it would be an in-house asset of the fund under section 71.

Technically, this position is incorrect because the residential property would become an in-house asset only once the fund leased it to a related party.

Ultimately, the ATO has the power to determine the status of assets within an SMSF. Section 71(4)(b) SIS provides the ATO with the authority to deem any asset as an in-house asset if it arises from a scheme.

It means the ATO can classify assets involved in such arrangements as in-house assets, underscoring the importance of SMSF trustees being vigilant in their compliance and asset-acquisition practices.

Compliance or Investment Advice

Moving forward, SMSF auditors should be careful in providing compliance advice regarding how to rectify section 66 breaches in their management letters.

Selling an illegally acquired asset is not the solution, and this advice is technically incorrect.

Additionally, it might be mistaken for investment advice, which could lead to various legal challenges, particularly if the SMSF incurs losses from the sale.

Conclusion

With section 66 breaches now being reported once, it remains essential for SMSF professionals to closely monitor transactions and ensure that trustees are doing the right thing.

Given the ATO's ongoing focus on compliance and education, the section 66 blind spot may be fleeting if we receive further guidance and information from the Regulator.

It is in the best interests of SMSF professionals and their trustee clients to review the ATO's updates and guidance as they become available.

Return to Articles

Ro