SMSF investing in private companies: Key rules to know

Another issue that SMSF trustees need to consider before investing in a private company is how the investment will be made. Will the private company be issuing new shares to the SMSF, or is the SMSF buying existing shares from an existing shareholder?

This is important as an SMSF is prohibited from acquiring assets from a related party. This would mean the SMSF could only invest in newly issued shares in the private company or acquire existing shares from an unrelated party.

Acquiring existing shares from a related party, including a family member or another related entity, would be in breach of the strict compliance rules and would result in financial penalties being levied on the trustees personally. It may also affect the complying status of the SMSF.

Be mindful of your investment strategy

SMSF trustees must ensure that all fund investments are made and maintained in accordance with the fund’s overall investment objectives.

Before investing in a private company, trustees need to check that the proposed investment is in line with the objectives set out in their investment strategy.

This would usually require the trustees to assess:

• The risk and return from any such investment
• How the investment would fit in with the fund’s other investments
• The effect the investment has on the fund’s overall diversification.

Comply with the in-house assets rules

The biggest compliance issue to address with these types of investments is the in-house rule, as an investment in a private company can often be caught as an in-house asset.

An in-house asset includes investments that an SMSF has in a ‘related company’ and a private company can easily become a related company.

This occurs where the SMSF alone OR together with any related party controls the company. Essentially where:

• A majority of the directors of the company are ‘accustomed or under an obligation’ to do what other people direct them to do; or
• The SMSF alone or together with related parties can cast more than 50% of the votes at a general meeting of the company.

There is a 5% limit imposed on the total value of all in-house assets held within the fund. That is, an SMSF can hold no more than 5% of its assets as in-house assets. Breaching this limit will result in compliance issues and often penalties will apply.

Follow the valuation guidelines

SMSF trustees will also need to consider the valuation requirements for all their fund assets. This would include the initial valuation assessment of the private company shares prior to any investment taking place, through to the requirement to value all SMSF assets at market value when preparing the fund’s financial statements.

It is essential that SMSF trustees follow all the valuation guidelines and rules.

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This can pose a real problem where the SMSF investments include shares in a private company. The trustees will need to consider what valuation process should be followed for these unlisted private company shares and how they can arrive at a fair market value for them. Not an easy process.

Luckily, the ATO has provided guidance for SMSF trustees on these valuation issues.

The ATO’s key requirements seem to be that the valuation process needs to be fair and reasonable and must be based on objective and supportable data.

The ATO comments include:

SMSF trustees need to maintain clear evidence around the process they have used to arrive at the market value.

Evidence to support your valuation of an unlisted security may include an independent expert valuation of assets held in the company or unit trust.

If an independent expert valuation is not available, provide:

• Evidence of how the market valuation was substantiated by the directors or trustees (of the private company), including objective and supportable data on which they relied
• The valuation method they used and any assumptions made.

You should consider using a qualified independent valuer if the:

• Asset indicates the valuation is likely to be complex
• The value of the asset (or assets) represents a significant proportion of the fund’s value.

Company or unit trust financial statements that are signed and audited, where the assets are valued at cost, are unlikely to be sufficient evidence on their own.

The bottom line

Private company shares are a legitimate SMSF investment, where that investment is being made for the right reason and is in line with the fund’s overall compliance requirements.

If you are considering making an investment in private shares through your SMSF, make sure you keep clear and accurate records of all your dealings relating to the investment and ensure that all transactions and dealings are carried out on arm’s-length terms.