SELF MANAGED SUPER FUND INVESTMENTS FAQ’S

1. What name do investments need to be in?
2. What is meant by the “Sole Purpose Test”?
3. What is required in an investment strategy?
4. What investments can an SMSF undertake?
5. Can an SMSF invest in direct property?
6. Can an SMSF invest in an ungeared unit trust?
7. Can an SMSF rent/lease a rental property to a member or related party?

1. What name do investments need to be in?

All investments undertake in the fund are held in the name of the trustees. The same rules that apply to trust’s in general apply the trustees of SMSF’s. ie the trustee of an SMSF must keep the funds monies separate from their personal dealings, and investments need to be held in the correct name(s) of the trustees of the SMSF.

For example John & Mary Smith As Trustees For (ATF) the Smith Family Superannuation Fund need to have all investments recorded as John & Mary Smith ATF Smith Family Superannuation Fund.

2. What is meant by the “Sole Purpose Test”?

This means that the dominant purpose of each transaction of the fund is to provide retirement benefits. It is possible that the trustees of a fund have a number of reasons for entering into a particular transaction. However, it is essential that the dominant reason is to maximise retirement benefits.

In Circular III.A.4, APRA has indicated that the sole purpose test may be breached where the nature of the fund's investments suggest there is a non-retirement purpose behind maintaining or purchasing an asset in the fund. One example of a fund failing the sole purpose test is the Swiss Chalet case where the fund was the holder of a Swiss chalet, a golf club membership and a holiday home. The family members use the chalet and holiday home on some occasions for their personal enjoyment, and sometimes without payment. The fund failed the sole purpose test for a variety of reasons including the way in which the family treated the fund's assets. It indicated they did not consider the assets to be that of the fund but rather that of the family.

This case highlights the need for SMSF trustees to ensure that they treat the fund separate from their own affairs.

Even more recently the aspect of incidental benefits to members has been highlighted by APRA and the ATO making announcements about funds holding Coles Myer shares. It was announced that superannuation funds cannot acquire the new class of Coles Myer shares that have the shareholder discount card but may retain any old holdings that they have. The rationale for this action by the regulators is that the new class of shares require the investor to forgo a portion of the dividend income to receive the discount card. As this discount card is only for the benefit of members and does not provide any retirement benefit it is not seen as an incidental benefit as the fund must forgo dividends ( ie cashflow to increase retirement benefits) to provide this non-retirement benefit.

3. What is required in an investment strategy?

An Investment Strategy is an integral requirement in managing a SMSF.

The investment strategy should be signed off by the Trustees, reviewed regularly and all investment decisions and transactions must be governed by the strategy.

Trustees must formulate and give effect to an investment strategy that has regard to the whole of the circumstances of the entity including, but not limited to, the following:

1. the risk involved in making, holding and realising, and the likely return from, the entity's investments having regard to its objectives and its expected cash flow requirements;
2. the composition of the entity's investments as a whole including the extent to which the investments are diverse or involve the entity in being exposed to risks from inadequate diversification;
3. the liquidity of the entity's investments having regard to its expected cash flow requirements;
4. the ability of the entity to discharge its existing and prospective liabilities; and
5. if there are any reserves of the entity—to formulate and to give effect to a strategy for their prudential management, consistent with the entity's investment strategy and its capacity to discharge its liabilities (whether actual or contingent) as and when they fall due.

From 1 July 1996 there can be substantial penalties applying to trustees of SMSF’s who do not have an investment strategy in place.

Ref: SIS Act 1993 Section 52(2) and 4, Section 59

4. What investments can a SMSF undertake?

Per the ATO guide for trustees running a SMSF www.ato.gov.au/super

The superannuation law does not state exactly what a fund can and cannot invest in. It does however restrict some investment practices of superannuation funds. The investment restrictions aim to protect fund members by ensuring fund assets are not overly exposed to undue risk (for example the possible risk of an associated business failing). Secondly, they aim to ensure that funds make investment decisions with the primary purpose of generating retirement benefits for members rather than providing current day support.

Investment rules are one of the most important requirements of SISA and failure to comply with the rules could result in trustees being fined and/or the fund losing its compliance status.

Loans/financial assistance to members or a member's relative

Trustees are prohibited from lending money or providing financial assistance from the fund to a member or a member's relative. The use of a fund asset by a member or a member's relative for no cost or as a guarantee to secure a personal loan for example would be in contravention of this investment restriction.

Borrowings

SMSFs are prohibited from borrowing money except in some limited circumstances. Trustees are able to borrow for a maximum of 90 days to meet benefit payments due to members or to meet a surcharge liability as long as the borrowing does not exceed 10% of the fund's total assets. Trustees can also borrow for a maximum of 7 days to cover the settlement of security transactions if the borrowing does not exceed 10% of the fund's total assets. However, trustees cannot, as a matter of course borrow to settle security transactions, unless at the time the transaction was entered into it was likely that the borrowing would not be needed.

Acquisition of assets from a related party

Trustees are prohibited from acquiring assets for the superannuation fund from a related party of the fund. Limited exceptions to this rule exist, if:

• the asset is an in-house asset and would not result in the level of in-house assets of the fund exceeding 5% of the fund's assets, or is an asset specifically excluded from being an in-house asset;
• the asset is a listed security (e.g. shares, units or bonds listed on an approved Stock Exchange);
• the asset is business real property.

Business real property of an entity generally relates to land and buildings used wholly and exclusively in a business. Trustees are permitted to acquire up to 100% of the fund's total assets in the form of business real property from 12 May 1998 (previously 40%).

Related party of a fund

A related party of a fund covers all members of the fund and their associates and all employer sponsors of the fund and their associates.

Associates of members would include their relatives, business partners and any companies or trusts that they control (either alone or with their other associates).

Associates of employers would include business partners and any companies or trusts that the employer controls (either alone or with their other associates) or companies and trusts which control the employer.

In-house assets

An in-house asset is a loan to, an investment in, and leases with, a related party of the fund. In general, SMSFs are restricted from lending, investing or leasing more than 5% of the fund's total assets in a related party of the fund.

Some exceptions do exist, including allowing an exemption for business real property which is subject to a lease between the fund and a related party of the fund and a limited exemption for certain investments in related non-geared trusts or companies.

Investments to be made and maintained on an arms length basis

Investments by SMSFs must be made and maintained on a strict commercial basis. The purchase and sale price of fund assets should always reflect a true market value for the asset. Income from assets held by the fund should always reflect a true market rate of return.

Changes to the Investment Rules

The investment rules outlined in this section incorporate amendments which received Royal Assent on 23 December 1999. The main changes from the previous rules are:

• previously only acquisitions of assets from members and relatives were restricted, now acquisitions from the broader category of related parties are restricted;
• previously only investments in certain employers and their associates were considered in-house assets and subject to the 5% restrictions, now investments in the broader category of related parties (which includes related trusts) are restricted to 5%;
• previously assets being leased to related parties were not considered in-house assets, now they are and are thus generally restricted to the 5% limit; and
• previously the exemption allowing the acquisition of business real property only applied if property so acquired was less than 40% of fund assets, now the percentage is effectively 100%.

These changes have applied from 11 August 1999, not 12 May 1998 as previously proposed. An exception is the change to the acquisition of business real property which applied from 12 May 1998.

Transitional rules

A number of transitional measures apply to the introduction of the new rules. These are as follows.

Existing investments at 11 August 1999

Fund investments and leases in place at 11 August 1999, are not subject to the new rules. That is, they are not counted as in-house assets (unless they were already in-house assets under the old rules).

A fund cannot, however, make additional investments in such an arrangement (e.g. purchase additional units in an existing related trust investment) unless specifically allowed under the transitional rules discussed below.

Certain specified investments after 11 August 1999

Certain specified investments made after 11 August 1999 will also not be subject to the changes. Funds can choose to take advantage of one (but not both) of the following exemptions:

• if a fund had an investment in a related entity (e.g. a trust) at 11 August 1999 it can make additional investments in that trust after that date (provided the investments do not exceed the level of the debt in the trust at that date and are made no later than 30 June 2009); or
• if a fund had an investment in a related entity (e.g. a trust) at 11 August 1999, it can, after that date but not later than 30 June 2009, reinvest earnings from that trust back into the trust. Also, if a fund had partly paid shares or units at 11 August 1999 it may make additional payments on those shares or units after that date (provided they are made no later than 30 June 2009).

If in any doubt the validity of an investment decision trustees should seek professional advice or contact the ATO for assistance.

Investments made between 11 August 1999 and 23 December 1999

In-house asset investments made between 11 August 1999 and 23 December 1999 were not subject to the in-house limits until 1 July 2001 (provided they would not have been captured under the previous rules).

5. Can a superannuation fund invest in direct property?

This is particularly so for Self-Managed Superannuation Funds. Most large superannuation funds invest in the property market as a means of achieving long term rates of return on income above the cash rates.

Investment in property is also seen as a means of obtaining long term capital growth.

The trustees of the SMSF need to consider a number of issues in determining the appropriate asset allocation to be directed to the property sector, the foremost issue is the expectations of returns from the property market. Trustees also need to have regard to the illiquid nature of direct property investment and the effect that this lack of liquidity will have on their capacity to meet benefit payment obligations as they fall due.

There are no restrictions on the ability of the trustees of the SMSF to invest in property, or indeed, the proportion of a fund that can be invested in property (subject to the fund’s investment strategy and the rules pertaining to the acquisition of assets and in-house assets).

However, the issues of liquidity and the diversification of investment risks will generally mean that a prudent investor would not have a large exposure to just one asset class allocation.

6. Can an SMSF invest in an ungeared unit trust?

The trustee of a self managed superannuation fund can invest in certain related companies and unit trusts.

This regulation allows a superannuation fund and a related party to jointly own a company or trust that owns business real property and lease that property to members or employer sponsors. The following requirements must be met for the investment to be exempt from the in-house asset rules:

1. The company or trust does not borrow;
2. There is no charge over an asset of the company or trust;
3. The company or trust does not invest in or lend money to individuals or other entities (other than deposits with authorised deposit taking institutions);
4. It has not acquired an asset from a related party of the superannuation fund (after 11 August 1999) other than business real property;
5. It does not acquire an asset (apart from business real property) that had been owned by a related party of the superannuation fund in the previous three years (not including any period of ownership prior to 11 August 1999);
6. It does not directly or indirectly lease assets to related parties, other than business real property;
7. It does not conduct a business; and
8. It conducts all transactions on an arm’s length basis.

If one of these conditions is breached, the investment in the related trust or company will be subject to the in-house investment limit.

Ref: SIS Act 1993, Sections 66(2A) and 71(j) SIS Regulations 1994, Regulation 13.22B or 13.22C

7. Can an SMSF rent/lease a rental property to a member or related party?

Has a contravention of Division 3 of Part 8 of the Superannuation Industry (Supervision) Act 1993 (SISA) occurred when a self managed superannuation fund (SMSF) leased residential property to the member/s of the SMSF and the value of the leased property compared to the total assets of the fund exceeded the in-house asset limits set out in Division 3 of the SISA?

Decision

Yes, a contravention of Division 3 of the SISA has occurred when the SMSF leased residential property to the member/s of the SMSF.

Facts

The SMSF owns a residential property.

After 23 December 1999 the SMSF leased the property to the member/s of the fund for residential purposes.

Reasons for Decision

Under section 71 of the SISA an in-house asset of a SMSF includes ‘… an asset of the fund subject to a lease or lease arrangement between the trustee of the fund and a related party of the fund’. The only exception is where the asset subject to the lease or lease arrangement is used in a business carried on by the member or some other person.

Subsection 10(1) of the SISA provides that a member of a fund is a related party of the fund.

As the lease arrangement was between the members of the SMSF in their personal capacity and the trustees of the SMSF, the asset will be considered an in-house asset. A contravention of the SISA will occur if the market value ratio of the SMSF’s in-house assets exceeds 10 percent of the value of the total assets of the fund at the end of the 1999-2000 year of income.

Reference: ATO ID 2002/659, Superannuation Industry (Supervision) Act 1993 Section 71 Subsection 10(1)

Disclaimer

No investment advice provided to you. This web site is not designed for the purpose of providing personal financial or investment advice. Information provided does not take into account your particular investment objectives, financial situation or investment needs. You should assess whether the information on this web site is appropriate to your particular investment objectives, financial situation and investment needs. You should do this before making an investment decision on the basis of the information on this web site. You can either make this assessment yourself or seek the assistance of any adviser.