Accounting partners are well aware of the Future of Financial Advice (FOFA) legislative changes related to offering advice on self-managed super funds (SMSFs) and the removal of the accountant’s exemption which allowed them to provide advice on setting up SMSFs Business without the need for an Australian Financial Services Licence (AFSL).
Those that want to continue servicing their clients with SMSF advice, or build strength in this growing sector, are now faced with making decisions on the best way forward.
Over the past 12 months, we have talked to over 500 accountants across Australia – many of the business owners of two to six partner firms and members of the three accounting associations – all with different opinions and approaches to the changing landscape of their industry.
Generally, you are not allowed to use your SMSF to run a business, borrow money or acquire a holiday house. These “grey area” investments are referred to as in house assets. In house assets can make up only 5% of the total asset value of a Fund, so be careful not to breach the SMSF sole purpose test. The most important consideration with an SMSF is that all investments are for retirement purposes only.
Running a business in an SMSF is generally considered a strong indicator that the fund has breached the sole-purpose test. In a limited number of circumstances, you can run a business in an SMSF. Still, anyone thinking of doing so is strongly advised to have a thorough read of the ATO fact sheet ‘Carrying on a business in an SMSF’ released 25 May 2010. An SMSF must be administered for the sole purpose of providing retirement benefits for Fund Members. Any investment decisions taken must be for the sole purpose of deriving a future retirement benefit and not a current service.
The choice between becoming self-licensed or an authorised representative of a licensee is an important decision, and many accountants are bewildered by these options.
While most partners are predominantly concerned with the cost implications of change, some are limiting their focus on application fees to obtain a licence rather than reviewing the totality of the costs of operating under and maintaining a licence.
Many are also neglecting to explore the non-financial criteria that play a critical role in determining the best option for the business. This includes:
- The type of SMSF advice they want to offer their clients;
- The time investment needed to maintain a licence;
- The complexity level of getting their SMSF advice capability up and running in their business; and
- The opportunity cost of waiting until June 2016 or worse still, doing nothing at all.
There is no question that accountants will benefit from expanding the advice side of their business. In fact, the legislative change should be seen as a positive catalyst to thoroughly assess the long-term growth strategy and succession plan of the company and, accordingly, adjust the business plan.
Whatever decision is made, knowing the implications on your business – the real cost of licensing – is crucial. It is a decision that must be addressed to ensure the company continues to remain relevant, a participant in the changing marketplace and meeting the expectations of your clients.
As head of SMSF Advice Limited, Stuart Abley brings a strong knowledge of the financial planning and accounting industries and how they can work together effectively.
Through our conversations with accountants, we’ve noticed there are three mindsets in the current market:
- Those who see the opportunities but aren’t sure how to make it work in their business.
- Those who are putting the decision of licensing off thinking they have enough time to consider their options without knowing the time required to get prepared
- The early adopters whose business models are already changing to take advantage of the legislative change.
What is an SMSF limited recourse borrowing arrangement?
An SMSF limited recourse borrowing arrangement typically involves an SMSF taking out a loan from a third party lender or from a related party, such as a member of the fund. The SMSF then uses the loan, together with its own available funds, to purchase a single asset (usually a residential or commercial property) that is held in a separate trust.
The SMSF trustee acquires a beneficial interest in the asset with the trustee of the separate trust being the legal owner of the asset. The SMSF trustee has a right to acquire legal ownership of the asset by making one or more payments. Any investment income received from the asset goes to the SMSF, and if the SMSF defaults on the loan, the lender’s rights are limited to the asset held in the separate trust. This means there is no recourse to the other assets held in the SMSF.
Can My Smsf Lend Me Money?
No. Your SMSF cannot lend you or any of your relatives’ money. Making this type of loan must be avoided: it’s not a way of legally accessing super early via an SMSF.
Section 65 of the SIS Act prohibits superannuation funds, including SMSFs, from providing financial assistance to members or their relatives.
The trustee or an investment manager of a regulated superannuation fund (SMSF) must not:
- lend money of the fund to:
- a member of the fund; or
- a relative of a member of the fund; 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.
Breaching this provision could lead to an administrative penalty of 60 units ($12,600 per trustee) as well as disqualification from being a trustee of an SMSF and civil and criminal penalties.
Can My Smsf Loan Money To My Business?
In general, loans to a business operated by members of an SMSF is prohibited and can result in the following administrative fines:
- Lending to members and relatives – 60 penalty units
- In-house assets – 60 penalty units
Currently, a penalty unit is $210, therefore each breach is $12,600 per trustee and penalties must be paid by the trustee personally (or on behalf of the corporate trustee) and not paid by the SMSF.
The ATO has more information on how they deal with non-compliance on their website.
There are however certain loans to a related party business that can be made under strict conditions that will not breach these tight rules provided they are correctly put in place. Having your SMSF drive a small loan to your business may be a way of legally accessing super early via an SMSF.
The key restrictions are:
- The loan is made to a company or a trust with a corporate trustee (not to a sole trader business or partnership)
- The amount of the loan is less than 5% of total fund assets (based on market value)
- The loan is on arm’s-length commercial terms
- The loan is allowable under the trust deed of the SMSF and is included as part of the investment strategy of the SMSF
- The loan does not breach the sole purpose test
In many cases, a loan of less than 5% of the assets of the SMSF may not be a significant amount. For an SMSF with a $1 million balance, this only equates to $50,000, which may not be enough for a business owner to survive through extended business disruption.
One key risk with a 5% loan is what happens when the market value of assets of the SMSF drop, and the loan increases to greater than 5% of the assets of the fund. Where the cost of the loan to the related party (i.e. the in-house asset) exceeds 5% of the assets of the fund at the end of the financial year, the trustee (s) of the SMSF must put in place a written plan to rectify the excess by the end of the next financial year.
For example, if a loan is made of $50,000 in April 2020 (based on the market value of total SMSF assets of $1 million) however the value of all assets drops to $900,000 as at 30 June 2020, before 30 June 2021 the trustees must reduce the loan amount to under 5% again – i.e. the $50,000 would need to be reduced to less than $45,000 to prevent the investment being considered an in-house asset.
Can an SMSF invest in a private company?
Your SMSF can invest in a private or public company, even if you work there. The criterion is that you do not have a controlling voting right. If you do, your investment will be regarded as an in-house asset, which cannot be more than 5% of your total SMSF’s assets.
See the ATO Tax Ruling 2009/4 on investments in companies that are considered related parties. Paragraph 157 of the ruling states that when you control 50% of a company, an investment in the company is regarded as an in-house asset.
Carrying on a business of share trading
To the question: Is it acceptable to trade shares in an SMSF? The short and simple answer is YES.
All the significant retail superannuation funds trade shares. When investing in Superannuation, buying, and selling are inevitable too.
The question of the acceptable level of share trading is a little more difficult to answer. There’s no real guidance in this area apart from the fact that your SMSF’s Investment Strategy should support trading. When Superannuation Warehouse sets up a new SMSF, we provide you with an Investment Strategy template. As Trustees of the Self-managed Superannuation Fund, it’s up to you to make sure that what you plan to do or trade is noted down in the Investment Strategy.
Whether an SMSF is an active share trader or an investor is determined case by case and depends on the intention of the trades, i.e. why the buys and sells are made. In court cases, factors taken into account to establish the trading status of an SMSF are as follows:
- The nature of the fund’s activities, mainly whether they have are aimed at making a profit
- The repetition, volume and regularity of the activities, and their similarity to the activities of other businesses in your industry
- The keeping of books of accounts and records of trading stock, business premises, licenses or qualifications, a registered business name and an Australian business number
- The volume of the operations, and
- The amount of capital employed.
Why is this important?
Because, as Trustees, you don’t want to breach the sole purpose test (providing retirement benefits to members). If you do, you run the risk of losing the concessional tax treatment given to SMSFs.
Is share trading etc. “carrying on a business”?
The ATO also has concerns that some investment activities by SMSF Trustees — such as share trading and making certain ‘tax-effective’ investments — may amount to carrying on a business. If those activities are carrying on a company, then — again — the SMSF may lose its complying status and the Trustee or SMSF may face penalties.
The ATO’s concerns outlined above reflect its regulatory imperatives in ensuring SMSF Trustees comply with:
- the sole purpose test, and
- investment rules in general.
It is important that Trustees are aware of, and comply with, the investment rules set out in the SISA. The key things to remember are:
- develop an investment strategy and stick to it, and
- make and maintain investments on an arm’s length basis. This can be determined by asking whether a prudent person acting with due regard to his or her own commercial interests would have made such an investment.
Trustees must NOT:
- acquire assets from related parties (although there are certain exceptions); or
- lend to, or provide financial assistance to, other members of the SMSF or to their relatives.
A Trustee might decide that playing roulette would make a good investment strategy, and “invest” in red or black. As long as it is an investment strategy, the trustee can go with it. It is legal. Now, although we would never condone anything as extreme as this, it does illustrate just how much freedom and responsibility the trustee is given when it comes to acting in the best interest of the SMSF.
What are the key benefits of SMSF Borrowing Arrangement?
Leverage your superannuation savings – An SMSF limited recourse borrowing arrangement allows your SMSF to borrow for investment purposes. Borrowing to invest or “gearing” your superannuation savings in this manner enables your fund to acquire a beneficiary interest in an asset that your fund may not otherwise be able to afford (it could be a business premise you own or operate your business from).
Although your SMSF is not the legal owner of the asset, your SMSF acquires a beneficial interest in the purchased asset, meaning your fund is entitled to receive all of the income (such as rental income) derived from the asset. Your SMSF is also entitled to receive any capital gains when the asset is sold.
Tax concessions – Investment income received by your SMSF, including any income received because your fund holds a beneficial interest in an asset acquired under a limited recourse borrowing arrangement, is taxed at the concessional superannuation rates.
If your fund is in the accumulation phase, this means the income received from the asset will be subject to no more than 15% tax. This could result in your fund paying considerable lower rates of tax on the income received compared with owning the asset in your own name or under a company or trust structure.
Furthermore, if the income received from the acquired asset is being used to support the payment of one or more superannuation income streams from your fund, the income, including realised capital gains, is exempt from tax in your fund.
Asset protection – Generally, superannuation assets are protected against creditors in the event of bankruptcy. This protection extends to support that the superannuation fund has acquired a beneficial interest in. Therefore, structuring the acquisition of an asset under a limited recourse borrowing arrangement may provide greater asset protection benefits than may otherwise be the case.
What are the key risks of SMSF Borrowing Arrangement?
Only certain assets can be acquired – Only assets that the SMSF trustee is not otherwise prohibited from acquiring can be purchased under a limited recourse borrowing arrangement. Generally, this means assets that you or a related party currently own cannot be acquired under a limited recourse borrowing arrangement. However, some exceptions do apply to business premises and listed securities that you or a related party own.
It is also a requirement that the asset acquired under a limited recourse borrowing arrangement is a single asset. This generally means shares in a single company that have equal legal rights or a property that has been constructed on a single traditional title. In some situations, properties constructed across one or more legal titles can still be considered a single asset under a limited recourse borrowing arrangement but only if there is a physical object (such as a building), or there is a State or Territory law that prevents the separate legal tiles from being sold separately.
If an SMSF acquires an asset that does not meet the above rules, the SMSF trustees may be required to sell the asset at a substantial loss to the SMSF. The SMSF trustees may also be subject to monetary penalties and other sanctions for breaching the superannuation borrowing rules.
Property alterations and funding improvement costs – Assets acquired under a limited recourse borrowing arrangement cannot generally be replaced with a different asset. In a practical sense, this means, during the life of the loan, alterations to a property acquired under a limited recourse borrowing arrangement cannot be made if it fundamentally changes the character of the asset. For example, property alterations that have the effect of changing the nature of a property from a residential to a commercial property during the life of the loan are not permitted. However, alterations or improvements to the property that has the effect of improving the functional efficiency of the asset, but do not change the character of the asset, are permitted provided borrowed funds do not fund them.
Maintenance and repair costs associated with the acquired asset can be funded from borrowed funds, including a drawdown from the loan used to acquire the asset.
SMSF trustees may be subject to monetary penalties and other sanctions if the replacement asset rules are breached.
Cost – There may be additional costs associated with acquiring an asset under a limited recourse borrowing arrangement that otherwise does not apply. For example, an SMSF limited recourse borrowing arrangement requires a separate trust to be established and the drafting of separate legal instruments such as trust deeds and company constitutions (if the trustee of the separate trust is a corporate trustee). Financial institutions may also charge for vetting your fund’s trust deed, and the limited recourse nature of the loan can mean a higher rate of interest.
Liquidity – Loan repayments are required to be deducted from your fund. That means your fund must always have sufficient liquidity to meet the loan repayments. Careful planning is needed to ensure contributions and the fund’s investment income is sufficient to meet the loan repayments and other existing and prospective liabilities as they fall due. This is particularly important if the property is not able to be leased for any period, or one or more members are in the pension phase (due to the requirement for the fund to also meet minimum pension payment requirements).
Even for members in the accumulation phase, the contribution caps impose limits on the contributions that can be made on a concessional tax basis. This may limit the tax effectiveness of the limited recourse borrowing arrangement if non-concessional contributions are required to fund the loan repayments because the member’s concessional contribution cap has been utilised already.
It is also important for SMSF trustees to consider the need for life insurance should one or more contributing members of the fund die. Careful drafting of the fund’s trust deed is required to ensure the proceeds of a life insurance policy, in this scenario, can be used by the SMSF trustee to repay the loan.
If the SMSF trustee defaults on loan, the lender may take possession of the asset and sell the asset with the SMSF trustees receiving the sale proceeds less the outstanding loan amount. If there is a shortfall between the outstanding loan amount and the sale proceeds received, the lender will not have recourse to any other assets of the SMSF. However, a guarantor (if there is one) may be called on to make up the shortfall.
Loan documentation and purchase contract – The Australian Taxation Office has become aware that certain limited recourse borrowing arrangements entered into by SMSF trustees have not been structured correctly. Some of these arrangements cannot simply be restructured or rectified and unwinding the arrangement could require that the property be sold, causing a substantial loss to the fund.
To comply with the rules, the asset purchased under the limited recourse borrowing arrangement must be acquired in the name of the Security Trust with the SMSF trustee acquiring a beneficial interest in the asset according to the terms of the Security Trust Deed. The terms of the loan must be on a limited recourse basis with the lender having no access to assets of the fund if the SMSF trustee defaults on loan.
Tax losses and capital gains – Any tax losses which may arise because the after-tax cost of the property exceeds the income derived from the property are quarantined in the fund. This means the tax losses cannot be used to offset your taxable income derived outside the fund. Similarly, the value of a property acquired under a limited recourse borrowing arrangement cannot be used as security for other loans, meaning the value of the property, including the equity built up over time, cannot be used to purchase further properties outside the fund.
Governing rules and other matters – Trustees should always consider the quality of the investment they are making and whether entering into a limited recourse borrowing arrangement is consistent with the investment strategy of the fund. The governing rules of an SMSF must allow the trustee of the fund to borrow before any limited recourse borrowing arrangement can be entered into. Investments that are not consistent with the fund’s investment strategy, or are not permitted by the fund’s governing rules, could result in an action for recovery of loss or damage suffered by a person with a beneficial interest in the fund.