Changes to superannuation law over the years have prompted more and more individuals to consider purchasing investments using a SMSF. Although the appeal is an easy one to appreciate from a tax perspective because of the lower 15% tax rate, tax should not be the only consideration.
This article focuses on other aspects one needs to consider before using a SMSF to invest including:
- the sole purpose test;
- borrowing restrictions;
- the in-house asset rules; and
- the non-arms length income provisions.
For discussion purposes, this article uses the example of a proposed investment in shares in a private company to illustrate the operation of the investment rules in superannuation law
Is the investment appropriate for the SMSF?
Superannuation law requires a trustee of the SMSF to comply with the sole purpose test when administering the SMSF.
Very broadly, the sole purpose test requires the SMSF trustee to ensure that the SMSF is maintained for the purpose of providing superannuation benefits to a member on their retirement or to the member’s dependants on the death of the member. It is possible to meet the sole purpose test where the SMSF is also maintained for ancillary purposes such as disability benefits but the core purposes of the SMSF must be for retirement and death benefits.
Whether the purchase of private company shares complies with the sole purpose test depends on whether the investment is appropriate for retirement purposes having regard to the risk and rate of return on the shares. For instance, if the SMSF were to invest in shares in a highly volatile and risky private company, then there may be an issue as to whether such an investment satisfies the sole purpose test.
How will the SMSF fund the investment?
The next question to consider is how the SMSF will fund the purchase of the shares. There are three funding sources a SMSF can access, namely, members’ accrued benefits, further contributions from members and borrowings made under a limited recourse borrowing arrangement.
Where further member contributions are required to complete the share purchase, it is necessary to take into account the contribution caps that limit the amount a member can contribute to superannuation each financial year. These caps are indexed annually and currently are:
- $30,000 for concessional contributions (e.g. employer superannuation guarantee or contributions made under a salary sacrifice arrangement); and
- $180,000 for non-concessional contributions (i.e. contributions made from after tax income).
Members who are 49 years or over on the last day of the previous financial year have a slighter higher concessional contributions cap of $35,000.
Members who are under 65 years on 1 July are allowed to make $540,000 of non-concessional contributions over a three year period.
Penalty tax may apply to contributions which exceed the above limits.
The SMSF can only borrow under a limited recourse borrowing arrangement. This is an exception to the general rule that SMSFs cannot borrow. A limited recourse borrowing arrangement is a particular arrangement which involves the establishment of a custodian trust which holds the private company shares until the borrowing is repaid
Is the proposed investment a dealing with a related party?
To prevent the inappropriate use of SMSF funds by related parties of the SMSF, superannuation law contains rules governing dealings between a SMSF and its related parties.
Very broadly, a related party of a SMSF covers related parties of the SMSF’s members and entities controlled by SMSF members.
Generally a SMSF cannot acquire an asset from a related party. The two main exceptions to this rule are acquisitions of business real property and listed securities at market value.
Since the private company shares are not a listed security, the SMSF will not be able to acquire the shares if the vendor is a related party. The SMSF can acquire the shares from an unrelated party.
The in-house asset rules are the other main provisions regulating a SMSF’s dealings with related parties. The in-house asset rules prevent a SMSF from having more than 5% by market value of its assets as in-house assets. Where a SMSF exceeds this 5% limit, the SMSF trustee must dispose of its in-house assets to get under the 5% limit.
Broadly, an ‘in-house asset’ is:
- a loan to, or an investment in, a related party of the SMSF;
- an investment in a related trust of the SMSF; or
- an asset of the SMSF that is leased to a related party.
There are some exceptions to the in-house asset relating to business real property and investments in non-geared trusts and companies.
The proposed private company share investment would have in-house asset issues if the investment caused the SMSF to acquire more than 50% of the shareholding in the private company or if directors of the private company were accustomed to act in accordance with the wishes of SMSF members. This is because the proposed share investment would be an in-house asset.
The SMSF would not be affected by these related party rules where it acquires the private company shares from an unrelated party, the shares do not represent a majority interest in the private company and SMSF members do not control the board of directors of the private company
Will the dividend received on the shares be arm’s length dividends?
A final issue to consider, and one which is often missed, relates to whether the income derived from a SMSF investment (in this circumstance, the private company shares) is affected by the non-arm’s length provisions in tax law.
The non-arm’s length provisions are aimed at ensuring that income is not inappropriately diverted to a SMSF to take advantage of the lower 15% superannuation fund tax rate. The non-arm’s length provisions apply where a SMSF derives income from a non-arm’s length arrangement. Where the provisions apply the SMSF is taxed on the non-arm’s length income at the highest marginal rate (currently 47%).
The arm’s length provisions have a wide reach. The fact that the SMSF’s purchase of the private company shares was at arm’s length sometimes may be not enough to prevent the provisions applying. For instance, if the private company enters into a non-arm’s length dealings and distributes the profits made from those dealings to the SMSF then the arm’s length provisions may apply depending on the circumstances.
Where a SMSF makes an arm’s length investment in a private company and the private company does not engage in non-arm’s length dealings with the SMSF or its related parties, then the SMSF should generally not be affected by the non-arm’s length provisions.
Summary
A SMSF is the most tax effective investment vehicle in the marketplace and there can be real benefits using a SMSF for investment. However, there are a number of superannuation and tax law issues to consider when using a SMSF to invest. These issues are not insurmountable and can be navigated with proper advice.
