Arm's length SMSF valuations

What does arm's length mean for an SMSF?

It means the fund deals with a related party only on terms an unrelated party would have agreed. The ATO's guide to valuing SMSF assets says investments must be made and maintained on an arm's length basis, prices should reflect a true market rate of return, and the value must rest on objective and supportable data.

Related party has a wide meaning. The ATO's investment restrictions page lists every member, their relatives and business partners, and any company or trust a member or their associates control or influence.

The ATO treats a valuation as fair and reasonable when it:

• is based on objective and supportable data
• considers all relevant factors
• is undertaken in good faith
• uses a rational and logical process
• can be explained to a third party

When does an arm's length dealing need a market value?

Whenever the price of a dealing with a related party is something the auditor or the ATO could question. For the assets we value, that is usually one of the situations in this table.

Selling to a related party. A fund that sells shares or units to a member, a relative or their company needs to show the price was market value, and a valuation at the sale date is the evidence. The ATO says to consider a qualified independent valuer where the asset is a significant proportion of the fund or the valuation is likely to be complex.

Buying from a related party. The ATO says a fund cannot acquire an asset from a related party unless the price reflects market value and the asset is a listed security, business real property, an in-house asset within the 5% limit, or an asset specifically excluded from the in-house rules. It adds, on its investment restrictions page, that private company shares are not listed securities and cannot be acquired from a related party. Because the Act also allows certain in-house assets to be acquired from a related party at market value within the 5% limit (s 66(2A)), whether a particular purchase is allowed depends on the facts, and that is for the trustees' legal adviser. See related-party transfer valuation and the in-house asset test.

Issuing new shares or units. The issue price is a price like any other. Issued below what the existing shares or units are worth, value moves to the new holder at the expense of the existing ones. Issued above it, the reverse. A valuation of the existing shares or units is the benchmark.

What is non-arm's length income, and why does price matter?

Non-arm's length income, known as NALI, is income the ATO taxes at the highest marginal rate instead of the concessional rate a complying fund normally pays. The ATO's guide to how SMSFs are taxed says a fund has NALI where it derives income from a scheme in which the parties were not dealing at arm's length and the income is more than would be expected if they had been, or where a private company dividend is not consistent with an arm's length dealing.

The rules are in section 295-550 of the Income Tax Assessment Act 1997. Since 1 July 2018 a fund also has NALI where income comes from such a scheme and the fund incurs expenses lower than would be expected at arm's length, including none at all.

The ATO adds that if an asset is not acquired or sold at arm's length, all or part of the income from the transaction may be non-arm's length income. That is why price matters in a related-party dealing.

How does a valuation support an arm's length dealing?

It gives the trustees, the auditor and the ATO a supportable figure to compare the actual price with. A suitably qualified business valuer at Valuation Group values the interest at the date of the dealing on the super law definition of market value: what a willing buyer could reasonably be expected to pay a willing seller, dealing at arm's length, after proper marketing, both acting knowledgeably and prudentially. The report sets out the evidence, method and assumptions and is built to be used as audit evidence.

The valuer is independent of your fund: never a member, trustee or related party of it. The ATO describes an independent valuer the same way, as someone who is neither a member nor a related party of the fund, and who is impartial and unbiased.

The law does not require a qualified independent valuer for an arm's length investment, only for collectables and personal use assets disposed of to a related party. The ATO recommends considering one where the asset is a significant proportion of the fund's value or the valuation is likely to be complex, and an auditor can seek an independent valuation as part of the audit. Unlisted shares and units often meet one or both tests.

What do we need to value an interest for an arm's length dealing?

Tell us the dealing, its date and how each party is related to the fund, then send:

• the contract or draft terms, with the price and date
• the company's or trust's financial statements for the last three years and the latest management accounts
• the constitution or trust deed and the share or unit register
• any earlier valuation and any recent sale between unrelated parties
• for a trust or company that holds property, its latest valuation by a registered or certified property valuer

Documents come through the private upload link on your matter, never by email, and your information stays confidential. Investment entity: $995 + GST. Trading business interest, turnover under $2 million: $1,495 + GST; $2 million to $10 million: $2,495 + GST; over $10 million: $3,495 + GST. We confirm the fee in writing before we start. No hourly billing.