SMSFs investing in unlisted shares – 3 challenges that might surprise you

Private company investments can be attractive for self managed super funds (SMSFs), particularly where members are looking for exposure to growth opportunities or investments that aren’t available on public markets. But before investing into these structures, it’s vital SMSF trustees assess the proposed investment for both super law compliance and tax issues. Here are three challenges which might surprise you.

1. Restrictions on buying shares from related parties,
2. Non-arm’s length income (NALI) risks, and
3. Market valuation requirements for unlisted shares.

Challenge #1 Buying private company shares from a related party

If a related party owns shares in a private company, an SMSF will usually be prohibited from purchasing those shares from the related party. Take for example Jenny who has a minority shareholding in the company Drones R Us Pty Ltd. This company is Jenny’s former employer, and although Jenny no longer works there, she thinks the company has good prospects for capital growth and would like to sell her shares to her SMSF at market value. Jenny’s holding is currently valued at around $50,000 and represents less than 5% of the SMSF’s total assets.  

Jenny gets a surprise though when her adviser tells her that the purchase of the shares from Jenny by her SMSF would be an illegal acquisition. Jenny questions her adviser because her SMSF has purchased holdings in managed funds from Jenny in the past.

But Jenny’s adviser is correct! Although an SMSF trustee is permitted to buy units in a widely held unit trust from a member at market value, no equivalent exception applies to shares in unlisted companies. In fact, the only private company shares that an SMSF would be permitted to acquire from a member are shares in companies the member and their related parties control. This seems counter-intuitive since SMSFs are limited on the amount of related party investments they can hold.  But alas, logic is not always found in super legislation.

Challenge #2 Non-arm’s length income risks for SMSFs investing in private companies

Another challenge with investing in private company shares is assessing whether dividends or capital gains derived from the shares will be non-arm’s length income (which is taxed at 45%). Take for example the receipt of dividends from private companies. Dividends from private companies are non-arm’s length income unless the dividends are consistent with an arm’s length dealing. Generally, the more “active” involvement related parties have with the company (such as being employed by the company, lending monies to the company etc), the more risk the SMSF may have in triggering a non-arm’s length dealing. Whilst non-arm’s length income isn’t illegal, it’s usually not preferable!

Challenge #3 Valuing private company shares in an SMSF

The ongoing requirement to value fund investments at market value can be challenging, particularly when the SMSF is a minority shareholder and other shareholders in the company don’t have market value reporting requirements. Unless shares in a private company are regularly traded between unrelated parties or there have been recent capital raisings, it may be difficult to secure the required information to allow the trustee to determine the market value of shares held and provide suitable evidence for the fund’s auditor.  

Holding shares in private companies via an SMSF certainly has its challenges, but it may attract renewed focus given the upcoming CGT changes for assets held outside super. 

To learn more about the key super and tax considerations when investing in private companies with an SMSF including a clear, step-by-step framework, to help you navigate compliance risks and structuring decisions with confidence, join us for our Super Intensive Day.  Register here.