Originally published in "Australian Financial Review"
Investors often talk about running a self-managed superannuation fund (SMSF) being difficult or risky. This is probably because trustees of SMSFs are ultimately responsible for complying with all the rules, many of which they don’t understand in detail. That sounds risky!
The truth is, investors who stick to simple, publicly accessible investments – listed shares, exchange traded funds, term deposits, cash, managed funds – can have a pretty easy SMSF life. The main things they really need to understand are how much they are allowed to put into their fund (contributions), when and how they are allowed to take money back out again and, if they want to do anything else, to get advice.
Think about it this way: we all lodge personal income tax returns but very few of us would claim to understand the tax rules in detail. Instead, we make sure we stick to some basic principles – declare all our income, claim tax deductions for the simple things and get advice if we’re doing anything complicated. SMSFs are much the same.
Where SMSFs can get more complicated is when they invest in assets that may be perfectly legal but are less common.
"Any SMSF buying any asset from a person or entity that is connected to them in some way almost certainly needs advice before going ahead."
So when it comes to investments, what are the important rules to keep in mind, and what are the triggers that show you should seek advice?
First, work out who or what owns the asset at the moment (the person, company, trust or other entity from whom the SMSF will buy it). There are strict rules about buying assets from related parties and generally the only things that are allowed are listed shares, managed funds and business property. Related parties are people like the fund’s members, relatives, partners and even entities like companies and trusts that the members and people close to them control. Any SMSF buying any asset from a person or entity that is connected to them in some way almost certainly needs advice before going ahead.
If the asset is something like property that will be leased to someone, also check who or what (person, company, trust or other entity) that will be. There are rules and limits about what kinds of assets can be leased to related parties, particularly if they represent a large proportion of the fund’s assets.
Make sure the whole transaction is completely arm’s length no matter who is involved – the fund needs to pay a market price for the asset and if it’s then leased to someone else that arrangement needs to be commercial too. Even with fairly mainstream investments like commercial property, getting this wrong can be disastrous. Ensure the rent is at market rates, is paid on time and is increased in line with normal market terms. Make sure it’s clear who is responsible for repairs and other costs and that they are paid by the right party (or reimbursed quickly if someone gets it wrong).
If the deal between the fund and the tenant is too generous to the fund, there’s a risk that the income from the asset and any profits (capital gains) made when it’s sold will get a special classification known as “non arm’s length income” and be taxed at 45 per cent rather than the usual superannuation rates.
If the deal is too generous to the other party (ie, someone from whom the fund is buying the asset or someone to whom it is being leased), the Australian Taxation Office will check closely to see if the SMSF members are secretly trying to get money out of the fund before they are allowed to or are providing financial support to family members. Both are illegal.
"Everything we do with superannuation money must be about saving for retirement or protecting people who depend on us if we die."
If the asset is what’s known as a collectable, there is a series of other rules on where it is stored, how it’s used, how it’s insured etc. Collectables include artwork, collections like stamps and coins, cars, jewellery – essentially anything that people buy because they enjoy owning or using them.
The trustee will need to place a value on the asset every year to prepare the annual financial statements. The value is important because it can drive the amount of pension that needs to be paid each year and sometimes even how much the members can contribute to super in the following financial year. If it’s an asset that’s difficult to value, think in advance about how this will be done and what it will cost. Saying “it’s too hard to value” to the ATO or the fund’s auditor won’t be an acceptable reason not to do so.
Every super fund has to document its approach to managing the fund’s assets (the investment strategy). Sometimes it is appropriate to provide extra detail to highlight any particular issues associated with the assets. For example, will the fund have a very high proportion of its investments in one thing? What (if anything) will the trustee do to minimise the risk of this highly concentrated approach? Will the fund have enough cash flow to meet its costs and pay benefits such as pensions? What happens if one of the members dies?
Finally – although this should actually be the first consideration – think carefully about why the asset is being bought or leased in the first place. Perhaps the most important superannuation rule we have is called the sole purpose test. A rough translation is that everything we do with superannuation money must be about saving for retirement or protecting people who depend on us if we die. The ATO and the courts have been known to look carefully at suspect transactions and ask exactly this question: why did the SMSF really do this? If there’s no good answer, don’t do it.