An SMSF is a very attractive superannuation savings vehicle but it also comes with plenty of responsibility for anyone that signs up to being a trustee. While most of the time people choose an SMSF because of the freedom of investment choice it provides, it’s important to understand the rules around what you can, and cannot, invest in.
The penalties for making a mistake now run into the thousands and it is the trustee that is ultimately responsible and could be banned or the fund taxed as non-complying.
All trustees need to sign a trustee declaration – a legal document that signifies they have understood all their legal requirements as a trustee.
Your fund will also have a trust deed. This is a document, which sets out how the fund will be run and operated. The trust deed and super laws together form the fund’s governing rules. So even if the superannuation laws allow you to invest in a particular asset class – such as international shares or property – the trust deed needs to stipulate this as well.
Your investment strategy will also need to set out why you wish to invest in these kinds of assets. (See our investment strategy guide here).
Sole purpose test
All superannuation funds need to comply with the sole purpose test, which means the superannuation fund is run for the sole purpose of providing retirement benefits for members.
The sole purpose test is for all superannuation funds and relates to SMSFs as per the following ‘Self-managed superannuation funds ruling SMSFR 2008/2: sole purpose test’.
The sole purpose test in section 62 prohibits trustees from maintaining an SMSF for purposes other than for the provision of benefits specified in subsection 62(1). The core purposes specified in that subsection essentially relate to providing retirement or death benefits for, or in relation to, SMSF members. The SMSF can also maintain the fund for one or more of these purposes and other specified ancillary purposes, which relate to the provision of benefits on the cessation of a member’s employment and other death benefits and approved benefits not specified under the core purpose.
Essentially if you, or anyone related to the fund, receives a financial benefit not related to your retirement then your fund might not be meeting the sole purpose test.
Assets in name of fund
It’s important when you do invest in assets to do it the right way. It is a legal requirement that you do it in the name of the fund, and not in your own name. Your SMSF is required to have its own bank account and fund assets must be held in the name of the individual trustees as trustees for the fund (or a corporate trustee).
This is for your own protection, as well as being a legal requirement. It means the assets belong to the fund, and not you, so they are somewhat protected in the event of a personal legal dispute against your assets.
The penalty for failing to keep the assets of the fund separate from members’ personal assets is 20 penalty units where each penalty unit is $210 and applies to each trustee, which would be $4200 for each member of the fund.
Investing in the name of the fund is relatively straightforward for most kinds of assets. However, for those funds that invest in property, if the property is not owned outright by the fund, they will have to be careful of what legal entity is the holder of the asset, particularly if they acquire the asset via a limited recourse borrowing arrangement (LRBA).
In these cases a security trust will need to be set up to acquire the asset, and it is the security trust which needs to be on the contract, however this will depend on what state the asset is in and it is important to get legal advice regarding this.
Restrictions (on investments)
An SMSF isn’t a free for all when it comes to investments and there are plenty of restrictions around what you can, and can’t invest in, which have evolved over time as the regulator cracks down on (real or perceived) loopholes. In addition to possible penalties for breaching the rules, your SMSF may lose its concessional tax treatment, which would increase its tax rate from 15 per cent to the highest marginal tax rate of 45 per cent (2018/2019). A trustee can also be disqualified.
For example, the regulations around collectables have tightened up since 2011 and now state that collectables or personal use assets cannot be stored in the private residence of any related party of the fund. The item must also be insured in the fund’s name within seven days of acquiring it. (See our guide on collectibles here).
On the other hand, rules around borrowing to buy assets such as property have evolved over time. Where originally it was barely allowed at all, a relaxation of these rules in 2007 means that in very specific circumstances SMSFs are able to purchase properties and occasionally other assets through limited recourse borrowing arrangements or through instalment warrants. Both of these types of borrowings limit the lender’s rights to the asset, i.e. the lender cannot claim on other assets held in the SMSF.
Also in very limited circumstances your SMSF can borrow money for a short period of time if that amount is less than 10 per cent of the fund’s total assets. Those circumstances are:
- A maximum of 90 days to meet benefit payments or to pay an outstanding surcharge liability; or
- A maximum of seven days to cover the settlement of security transactions. You can also only do this if when you bought the securities you did not think you would need to borrow funds.
All investments by your SMSF need to be made on a “commercial arm’s length basis”. If you invest in an asset you need to be getting an appropriate market rate of return for that. If you acquire (or divest) an asset, that needs to be at an appropriate market value as well. If it is not, you will be breaching the “arm’s length” requirements.
One of the biggest challenges for SMSF trustees around the arm’s length requirements are the rules about related parties and investments.
A related party is not just a relative or another member of your SMSF, it includes associates of all members of the SMSF as per the following ATO definition:
- The relatives of each member
- The business partners of each member
- Any spouse or child of those business partners
- Any company the member or their associates control or influence
- Any trust the member or their associates’ control.
‘Business partners’ refers to the situation where the member, or a relative, is a partner in a partnership and other partners in the partnership are included as related parties.
Employers who contribute to your superannuation and associates of employers who do so (business partners and companies or trusts the employer controls and companies and trusts that control the employer) are also related parties.
Problems arise when related parties, say a son or business associate, might sell an asset to an SMSF at below market value. That would be in breach of the “arm’s length” rule.
Income earned through the SMSF by activities conducted on a non-arm’s length basis is called non-arm’s length income (NALI) and is taxed at the highest marginal rate.
Assets that have connections to related parties are called in-house assets and are either an investment in a related trust of your fund, a fund asset that is leased to a related party, or an investment in (or a loan to) a related party of your fund. An in-house asset cannot be more than 5 per cent of your SMSF’s total assets at market value. Exceptions to this rule include business real property or commercial property.
A trustee’s company (as opposed to the property the business operated in) would not be an exception to the in-house asset test and therefore if the SMSF wanted to invest in it, it could only invest 5% of the fund’s assets in it. It would also have to invest in it at market value in accordance with the arm’s-length rule.
In a speech last year ATO Assistant Commissioner, Dana Fleming, cited in-house assets as one of seven areas where trustees commonly make mistakes.
She said such breaches were usually associated with a failing business and the need for cash to keep it afloat.
“The ease of withdrawing money from the SMSF’s bank account may motivate some trustees with cash-flow problems in their business to use the money in their SMSF to boost their business with the intention of paying back the money, but often they don’t,” she said.
The Assistant Commissioner suggested making a list of all related parties of the fund when the fund is established and checking investment restrictions if the fund ever contemplates transacting with any of the parties on the list.
Lending money and early access
Under Section 65 of the Superannuation Industry (Supervision) Act 1993, SMSF trustees are not able to lend money or give any other financial assistance using the resources of the fund to a member of the fund or a relative of a member of the fund.
Withdrawing funds from the SMSF to give to a relative of a member falls under “other financial assistance” and would in fact be early access to superannuation, which is illegal if the trustee has not met a condition of release that allows the trustees to pay the benefit.
However, an SMSF is able to lend to a related party, providing it is not a member or their relative, as long as it does not breach the in-house assets test and lend more than 5 per cent of the fund. It also has to be on an arm’s length basis, which would mean it would have to be a loan at market interest rates. If an SMSF did lend to a related party it would be advisable to write up a loan contract stipulating the amount, the term and the interest rate. The SMSF’s investment strategy would need to include how and why it benefited the overall retirement outcomes of the SMSF’s members.
Exotic investment instruments e.g. foreign currencies, commodities, options and crypto currency
Foreign currencies and commodities are usually traded via contracts for difference or CFDs.
SMSFs can invest in CFDs if they do not deposit fund assets with the CFD provider (for example for margin calls on the investment). However, the fund’s investment strategy and trust deed need to allow it, and explain how it benefits the fund, and a risk assessment statement – called a Derivatives Risk Statement – needs to be part of the investment strategy.
CFDs are a very complex leveraged instrument and any risk assessment statement should include an explanation of the trustee’s level of knowledge and experience with the asset class.
Options and crypto currency are also allowed as long as the trust deed allows it, and the investment strategy explains the motivation and includes a risk assessment statement.
Carrying on a business within an SMSF
Like many of the “out of the box” investments mentioned above, your SMSF can invest in a business if you can show that it is a business being run for the sole purpose of retirement savings, is conducted on an arm’s-length basis and is allowed under the trust deed. The investment strategy will have to explain why the SMSF considers investing in the business will increase the members’ retirement savings.
The ATO has cited the following as the kinds of cases that attract their attention when it comes to businesses conducted by the trustees of SMSFs:
- The trustee employs a family member (we look at things such as, the stated rationale for employing the family member and the salary or wages paid)
- The ‘business’ is an activity commonly carried out as a hobby or pastime
- The business carried on by the fund has links to associated trading entities
- There are indications the fund’s business assets are available for the private use and benefit of the trustee or related parties.
Essentially, your SMSF is able to invest in a vast range of investment options that include exotic investments along with the ability to invest in properties and businesses. However, if your SMSF does invest in these kinds of investments – for example something as exotic as crypto currencies – you will need to have a watertight investment strategy and Derivative Risk Statement showing how this will benefit the investment outcome of your SMSF for the retirement benefits of all the members.