SMSF investments are an area where myths abound. The basic rule is the trustees may invest as they wish provided they are satisfied the investment is in the members’ long term interests, in the sense of enhancing retirement benefits. This is subject to some specific rules concerning investments with related parties and acquiring assets from related parties. These rules were announced in the 1998 Federal Budget, but changed significantly before they were finally introduced.

If a SMSF acquires or holds an asset that is not permitted under the superannuation law it becomes a non-complying superannuation fund. This means the SMSF is exposed to a potential tax penalty equal to 47% of its assets, less undeducted contributions. It also means the trustees are exposed to civil and criminal penalties, including, in (very) extreme cases, a risk of a gaol sentence.

For this reason trustees will be wise to invest the SMSF’s assets conservatively, in the sense of sticking with the traditional choices of shares, cash and property and variations thereon, and to avoid non-traditional choices. Certainly assets or asset strategies that have lifestyle advantages (eg art, jewellery or residential properties in holiday areas) should be dealt with very carefully if not at all. Assets or asset strategies that seek to circumvent the rules against borrowing, and loans to or investments in related persons, should be similarly avoided.

If the SMSF trustees stick with the traditional choices of shares, cash and property there will be no problems. The problems are invariably caused by non-traditional investments. Having said this, the number of SMSFs that have non-traditional investments is actually quite small: we estimate it is easily less than 1%.

In general terms a SMSF must:

1. have an investment strategy;

 

2. must always deal on a strictly arms length basis;

 

3. must not borrow, except in very limited circumstances;

 

4. must not acquire assets from members and related parties unless they are certain listed shares and other securities, bank deposits, cash, life insurance policies or business real property;

 

5. must not lend money or provide financial assistance to members or related parties;

 

6. must not invest in in-house assets except in very limited circumstances.

A wise trustee adds a further basic rule: they must be able to prove the investment is in the members’ long term interests and that they considered all aspects of its expected performance before proceeding with it. This rule is not found in the SISA. It is a common sense rule we add to help keep trustees out of trouble with the Regulator. We stress this rule applies to all investments undertaken by a SMSF. In the following paragraphs we consider it in the context of an investment in art. This is a difficult area that we generally do not recommend but using a difficult example helps illustrate the point of interest.

If the trustees decide to invest in art or some other unusual investment they should:

1. log detailed reasons for doing so in the minutes of the trustees’ meetings;

 

2. obtain and retain information regarding the likely investment performance of art compared to traditional investments. This should include expert opinions on the value of the art and its prospects for capital gain (remember, the return is generally limited to capital gains since art does not produce income in the way a property produces rent or a share produces dividends);

 

3. ensure the investment strategy and the deed permit investments in art; and

 

4. be able to show the art was purchased solely for investment reasons and not to please someone’s sense of the aesthetic or to grace a lounge room wall.

Trustees will usually have a more conservative investment philosophy based on:

1. listed company shares, particularly blue chips;
2. bank accounts and other interest bearing investments;
3. real estate; and
4. similar investments.

The bulk of SMSF investments are Australian shares and interest bearing deposits. Properties come next, but these are surprisingly few in number, presumably because of the higher entry price, the lack of liquidity and because the tax benefits attached to property are worth less to a SMSF than they are to its members.

SMSFs are usually conservative investors. The media definitely overstates the incidence of non-traditional investments. Most SMSFs avoid risky and an unusual investments. As a group they are risk averse. Aboriginal art is (very much) an exception rather than a rule. It is unusual for trustees to go outside the traditional range of investments of shares, property and cash.

Probably less than one per cent of SMSFs have risky or unusual investments.

The basic rule is the trustees may invest in any asset they believe is appropriate. This is provided they are satisfied the investment is in the members’ long-term interests, in the sense of enhancing their retirement benefits. The exceptions relate to lending to members, acquisition of assets from members, borrowing, non-arm’s length assets, in-house assets and the sole purpose test.

Each of these exceptions is discussed in turn in the following paragraphs.

Under section 65 of the SISA SMSFs cannot lend money or provide other financial assistance to members or to relatives of members. Here "relative" means in relation to a person the parent, grandparent, brother, sister, uncle, aunt, nephew, niece, lineal descendant or adopted child of the person or the spouse of the person or any other person previously listed. "Providing other financial assistance" is not defined but is thought to include activities like guaranteeing a third party’s debts or other financial obligations.

(In strictness, section 65 does not prohibit a loan to a related party who is not a relative, as defined, for example, a private company that the member owns shares in. But such a loan is likely to breach the sole purpose test, the in-house asset test and/or the arms length test, and hence is otherwise prohibited under the superannuation law.)

A loan or other financial assistance cannot be made indirectly either. For example, a SMSF cannot place money with a financier on the condition the financier lend the money to the member’s spouse at the same interest rate. The SISA prohibits back-to-back loan arrangements designed to get around the rule against lending to members. (See APRA Superannuation circular No. II. D. 2 "Lending and provision of financial assistance to members and unit holders".)

In 2000 an Adelaide accountant was convicted and fined for facilitating arrangements to breach the rule against member loans. The accountant arranged for SMSF clients to lend money to entities related to each other on an apparently arms length basis. But in truth the loans were made on the understanding that the borrower’s SMSF would make a loan to the members of the lender SMSF, or a related party. The court had no trouble concluding that this breached the superannuation law. This case highlights the need to avoid strategies that are intended to circumvent prohibited practices. In most cases these strategies trigger anti-avoidance rules and do not achieve the intended result.

Section 66 of the SISA prohibits SMSF trustees from intentionally acquiring assets (other than cash) from members or related parties, such as family trusts. This is known as the rule against self-dealing or "the member asset rule". There are three exceptions to the member asset rule. These are:

1. "business real property" (basically real estate used in a member’s business, such as a doctor’s premises) from a member;

 

2. listed securities (ie shares, units, bonds, debentures, options, rights). The listing does not have to be on an Australian stock exchange; and

 

3. in-house assets provided the acquisition does not result in the SMSF breaching the in-house asset rule. This rule is discussed in detail below.

Care needs to be taken with non-cash undeducted superannuation contributions. These can comprise the acquisition of an asset from a member and can breach section 66. Specific advice should be sought before transferring assets from a member or a related entity to a SMSF. All assets acquired from members must be acquired at market value.

Sub-section 66(3) contains anti-avoidance rules to prevent arrangements intended to get around the purpose of section 66. In July 2001, the AAT found that two SMSFs entered into schemes to acquire property from their members, and therefore breached the prohibition on acquiring assets from members in section 66 of the Superannuation Industry (Supervision) Act ("the SISA").

In June 1995, Mr and Mrs L wanted to transfer a property owned by them to their SMSF. Sub-section 66(1) of the SISA generally prohibits a trustee from acquiring an asset from a member or from a member's relative. Mr and Mrs L instead implemented a complex series of transactions involving the issue and redemption of units in a unit trust that effectively allowed them to transfer the asset to their SMSF.

On 12 June 1995, Mr and Mrs L established the L Property Trust ("the Unit Trust") with L Investments Pty Ltd as the trustee. L Investments Pty Ltd, as trustee of the L Family Trust ("the Family Trust"), was issued with 10 $1.00 units. The Unit Trust acquired an investment property for $100,000 from Mr and Mrs L. The Family Trust was issued with 102,936 units in the Unit Trust in return for assuming the debt of $100,000 connected to the property, and some cash.

Mr and Mrs L set up the L Superannuation Fund (No 2) ("the SMSF") with Mr and Mrs L as trustees. They rolled superannuation benefits of $130,751 into the SMSF. The SMSF was issued with 102,941 $1.00 units in the Unit Trust, and the Unit Trust redeemed 102,946 units owned by the Family Trust, and paid this cash to the Family Trust. The Family Trust paid out the debt owed to Mr and Mrs L. On 30 June 1995, the SMSF lodged an election to be a regulated superannuation fund.

A similar series of transactions was then executed for the W Superannuation Fund ("the "W SMSF") in June 1996.

The L Superannuation Fund (No 2) was given a notice that it was not a complying superannuation fund for the year ended 30 June 1995 and the W Superannuation fund was given a notice for the year ended 30 June 1996. This was on the grounds that the SMSFs had contravened the SIS Act, which prohibits, among other things, entering a scheme with the intention of acquiring an asset from a member of the fund where that acquisition would avoid the application of sub-section 66(1). This meant heavy tax penalties were assessed on the SMSFs. The SMSFs objected and then appealed against these assessments.

The SMSFs argued that they had not breached sub-section 66(3) of the SISA, as they simply acquired units in the Unit Trusts and that were not entitled to the underlying assets of the Unit Trusts. While the land had been acquired from the members by the Unit Trusts, the SMSFs did not acquire any property from the members and therefore did not breach sub-section 66(3).

The AAT found that the purpose of the transactions that were entered into in a short space of time were to use the SMSFs to acquire a property previously owned by the members. The AAT was satisfied that the series of transactions were planned in advance and comprised a scheme. It was satisfied that the scheme was entered into and carried out with the intention that the beneficial ownership of the property be transferred to SMSFs in a way that avoided section 66 of the SISA.

As the sole unit holder of the Unit Trusts, the SMSFs, at any time, may resolve to wind up the Unit Trusts and distribute the assets in specie. The SMSFs had the full equitable interest in the property and the capacity to call for the property to be transferred to them absolutely at any time. This was enough for section 66 to apply. The AAT found that sub-section 66(3) of the SISA applied to the transactions. Therefore the SMSFs were not complying superannuation funds.

The lesson is that clever attempts to get around the rules in the SISA do not work. The courts and the AAT are quick to strike them down. They take a purposive approach rather than a literal approach to interpreting these rules. Emphasis is given to the substance of the transaction rather than its form. SMSFs are well advised to take a very cautious and conservative approach to this SISA and the superannuation law generally.

"Business real property" means any freehold or leasehold interest used in a business. The business real property must be used wholly and exclusively in the business (except for certain dwellings on farming properties). "Business real property" is widely defined to include a profession, trade, employment or profit making activity carried on by or connected to a member. The definition excludes any interest held in the capacity of a beneficiary of a trust estate. Hence it does not include units in a unit hybrid trust where the trustee owns the relevant property.

Prior to 12 May 1998 there was a limit on the amount of business real property able to be acquired from members. No more than 40% of the SMSF’s assets can be used to acquire business real property from members. However, this cap was removed in 12 May 1998 and now there is no limit. All of the SMSF’s assets now can be used to acquire business real property from members if the SMSF wishes to do so.

Trustees may not borrow except in limited circumstance. This rule against borrowing applies to both excluded and non-excluded funds. It is intended to help safe-guard members’ interests and to insulate member’s benefits from the risk of debt.

The trustee can only borrow if the borrowing is a temporary borrowing to:

1. pay a beneficiary a benefit, provided the borrowing is not for more than 90 days and is needed to allow the payment to be made on time;
2. cover the settlement of a securities transaction, provided that the trustee believed at the time of entering into the transaction that a borrowing would not be required to settle the transaction, that the borrowing is not for more than 7 days and the total amount borrowed does not exceed more than 19% of the SMSF’s assets; and
3. pay the 15% superannuation surcharge provided the borrowing is not for more than 90 days and is needed to allow the payment to be made on time.

A SMSF cannot borrow to buy or hold investments. For example, a SMSF cannot borrow, say, 70% of the cost of a rental property, and provide 30% of the cost itself as equity. This would breach section 67 of the SISA and the rule against borrowing.

In practice SMSFs borrowing is quite unusual even within the limited areas explained above, We confess that we have never encountered a SMSF borrowing for any of these purposes, and suspect it is extremely uncommon. Faced with an inability to settle a transaction, pay a benefit or pay surcharge, the trustees are far more likely to simply defer the transaction for a short period rather than go to the trouble and cost, and risk, of a formal borrowing.

In summary, the rule against borrowing is well known and observed. It does not cause SMSFs any concerns.

If the trustees of a SMSF went to a bank and negotiated an overdraft facility that was then used outside the limited circumstances explained above, then this would be a blatant breach of section 67 of the SISA and the rule against borrowing.

More probably, the overdraft will arise by accident: at a particular time the trustees may have written more cheques out of a bank account than they have deposited. Instead of bouncing a cheque or cheques on the basis of insufficient funds, the bank honours the cheque. Has the SMSF breached section 67 of the SISA?

This is actually a common scenario.

The better view is there is no "borrowing" and therefore no breach of section 67. This is because the SMSF did not ask the bank to honour the cheques and the bank did not seek its approval before doing so (refer case 5/94 ATC 130). The Regulator has said that for a loan to breach section 67 it must arise in the context of a lender-borrower relationship and not some other relationship. Certainly without a deliberate intention to borrow, it’s hard to carve a section 67 borrowing out of this situation.

A similar problem arises if the SMSF acquiesces to a third party, say, a member, paying costs on its behalf, with the understanding that the SMSF reimburses the member later on. It is possible the understanding could amount to a borrowing. It depends on all the facts. We therefore generally recommend that the SMSF pay all of its costs direct and that third parties are not used. This makes it clear that section 67 is not breached and also keeps the audit trail simple, thereby reducing costs.

Under section 109 SMSFs may only invest on an arms length basis. This does not mean that trustees cannot deal with related persons, such as members and employers of members. It does mean that if trustees deal with related persons they must do so on ordinary commercial terms. For example, if a SMSF trustee sells an asset to a member’s trust the sale price must be market value. If a SMSF trustee rents a factory to a member’s employer the rent must be a market rent and, in particular, must be no more favourable than would reasonably be expected if the parties were not related. In other words:

1. the parties must be at arms length; or

 

2. they must deal with each on an arms length basis.

What does "arms length" mean? There is no definition in the superannuation law so we are forced back to general principles. Osborne's Concise Law Dictionary (7th edition, Sweet and Maxwell, London 1983) defines the phrase "at arms length" as:

The superannuation law does not stop persons, who are not at arm’s length, from dealing with each other. However, it does require the terms on which they deal with each other to be the terms that people who are at arm’s length deal with each other. Contract terms must always be commercial.

A wise trustee takes great care to show related party transactions are carefully documented to prove they occurred on an arms length basis. This means, for example, valuations will be obtained before selling an asset to a member’s family trust and real estate agents will be asked to advise in writing on market rents at regular intervals. If, for example, a related party tenant in a factory owned by a SMSF defaults then the SMSF trustees should commence all normal recovery actions, including eviction if need be. All trustee decisions will be carefully minuted and copies faxed to Super 2000 Pty Ltd at the time they are created. The records should be kept for at least ten years and made available to the Regulator should it wish to examine the transaction in any way.

Up to 11 August 1999 an "in-house asset" is a loan or an investment by a SMSF in an employer sponsor or an associate. The definition of "employer sponsor" was wide. It included associates of the employer sponsor and includes related companies, trusts, individuals and partners.

However, since then the concept of an "in-house asset" has been extended greatly. Under section 72 of the SISA the definition of an in-house asset now covers:

1. a loan to or an investment in a related party;
2. an investment in a related trust; and
3. an asset of the fund that is subject to a lease or lease arrangement between the SMSF trustees and a related party.

A "related party" in relation to an SMSF includes a member, a standard employer sponsor, and "Part 8 associates" ie controlled persons.

These terms are broadly defined and have a wide meaning. A wise trustee will look to the intention of the legislation, which is to prevent SMSF from lending money to or investing in related entities, and ensure that the SMSF does not do any of these things, and will not adopt an aggressively narrow view of these terms and hence the scope of section 72.

Some investments made before section 72 was enacted on 11 August 1999 are not in-house assets even though they would be if made after 11 August 1999. The best example of this is units in related unit trusts that have borrowed money to acquire property. In summary, these are not in-house assets if acquired before 11 August 1999, but will be in house assets if acquired after 11 August 1999 (except in limited circumstances).

The in-house asset limits are:

(i) up to 30 June 1998 : 10% of historical cost

(ii) from 1 July 1998 to 30 June 2000 : 10% of market value

(iii) after 1 July 2000 : 5% of market value

If a SMSF breaches these limits it will be a non-complying superannuation fund. This means it will be charged tax equal to 47% of the SMSF’s assets, less undeducted contributions, and the SMSF and its trustees will be liable for other civil and criminal penalties, depending on the degree of culpability.

The purposes of the in-house asset rules is make sure employee members' interests are protected from the risk of the employer’s business failing and from the risk of an employer deliberately defrauding a member. The Government is concerned that because of the connection between the SMSF and the related parties, the special tax concessions provided to SMSFs will be exploited. For this reason it has limited the extent of these transactions even though they may have been permitted under the other investment rules such as the sole purpose test and the arms length test.

There are a number of exceptions to the in-house asset rules. However, these are not relevant to SMSFs so we do not discuss them here.

There are anti-avoidance rules to stop trustees circumventing the in-house assets rule. Generally, if an arrangement is entered into for the purpose of circumventing the in-house asset rule the Regulator may ignore the arrangement and declare the underlying asset to be an in-house asset.

The in-house asset test has been progressively widened and tightened since August 1999. Transitional rules are in place to ensure that this widening and tightening does not have a retrospective effect. The potential application of these rules should be considered before concluding that a particular investment is an in-house asset.

The in-house asset rule is reinforced by the rule that taxes a SMSF at 47% on all income derived from non-arms length sources. A SMSF that breaches the in-house assets test is also likely to be in breach of the sole purpose test and the arms length rule. The sole purpose test is discussed briefly in the following paragraphs.

This is a general rule regarding the overall conduct of SMSFs. Investments must be made for the sole purpose of providing retirement benefits to members. This sounds like a simple rule but in practice it can lead to difficulties.

This rule is important. If a trustee contemplates an investment that has a purpose other than paying retirement benefits, such as a beach house, or a ski lodge, the overriding investment purpose should be extensively documented. With some understatement, we add that it helps if members and relatives do not use the beach house or the ski lodge for their own purposes.

Generally investments with aesthetic or lifestyle connections are to be avoided, as they have a huge potential to get the SMSF, the trustees and the advisors into a lot of trouble.