The Superannuation Industry (Supervision) Act 1993 (SISA) does not provide a comprehensive list of assets an SMSF can invest in. Instead, it provides rules and restrictions on what an SMSF can and cannot do. So basically, an SMSF can purchase any type of asset for investment purposes as long as it does not contravene any of the superannuation rules.
Sole Purpose Test
Firstly, the purpose of an SMSF is to provide retirement benefits or retirement related benefits (e.g. disability benefit, death benefit, reversionary benefit) for its members or dependents. So what that means is if an action of an SMSF can be perceived as providing personal or immediate benefit to its member or relatives, it will contravene the Sole Purpose Test provision under section 62 of the SISA.
Example 1 [Members purchasing a property via their SMSF and living in it]: Doris and Clive are members and trustees of their SMSF. They need a place to live and have combined accumulated superannuation savings of $500,000 in their SMSF. They use the money in the SMSF to purchase a residential home in their preferred suburb. They then move into the property to live and pay rent to the SMSF at the market rate. Doris and Clive did not think this was a problem as they were paying rent at the market rate which would be the same as if the SMSF’s property was leased to anyone else.
Example 2 [Member purchasing artwork via their SMSF and displaying it in his office]: Doris and Clive purchased a painting using money in their SMSF. The artwork needs to be stored somewhere, so they decided to display the painting at Clive’s business office. Doris and Clive did not think this is a problem as the artwork needed to be stored somewhere anyway and by displaying it at Clive’s office it is in a suitable air-conditioned office and kept safe as it is displayed in the public area where everyone can see it and enjoy it.
In both of the above examples the purpose of purchasing the assets is for personal benefit and personal enjoyment, and not necessarily for the members’ retirement. The members could argue that the house will increase in value by the time they retire or that the artwork would increase in value as time goes by. That may be true but it will still be perceived as using superannuation savings to gain an immediate private benefit and therefore the ATO may treat the investments as contravening the sole purpose test.
Often people establish SMSFs so that they can invest in assets that they have a personal interest in or are passionate about (e.g. art, jewellery, wine, cars). If their superannuation savings were in retail superannuation funds they may not have the choice to invest in such assets. The problem is of course once the assets are acquired by their SMSFs, it is often used by the members for their personal enjoyment. This means the assets may be at risk of being destroyed, depreciated, devalued and may not generate reasonable income/capital value for their retirement.
That is why the Government introduced a law back on 1 July 2011 which requires SMSFs investing in collectables and personal use assets to comply with strict superannuation rules. The rules are that if an SMSF purchases such assets, the assets:
- must not be leased to a related party of the SMSF;
- must not be stored in a private residence of a related party;
- must have a documented decision on the storage of the item and the document must be kept for ten (10) years;
- must be insured in the SMSF’s name within seven (7) days of being acquired;
- must not be used by a related party of the SMSF, and;
- must have an independent valuation if transferred to a related party.
Before we move further on the subject of acquisition, I would like to define what I mean by a “related party” of an SMSF. Normally most people would consider a related party to be someone who is related to a person by birth or marriage. The definition of a related party in the SISA, however, is very broad and includes just about anyone that is either related by birth, marriage or through operating a business together.
The definition of a “related party” under section 10 of the SISA includes:
- members of the SMSF;
- relatives of members of the SMSF;
- a partner in a partnership business in which an SMSF member is a partner;
- an associate of a partner in a partnership business;
- any companies where the members and/or their relatives in relation to the company hold more than 50% of the shares and voting rights in the company;
- any trusts where the members and/or their relatives in relation to the trust control the trust or have a fixed entitlement to more than 50% of the capital or income of the trust.
As this Bulletin is on the subject of SMSFs acquiring assets from “unrelated parties” we will only be discussing the relevant superannuation rules around unrelated party investment transactions. These are investment transactions conducted between parties who do not know each other or operate businesses together.
The second area of the superannuation law in relation to acquisition of assets is that all investment transaction must be conducted at arm’s length.
Arm’s length transactions
All SMSF investments must be made and maintained on a commercial basis. The purchase and sale price of all assets should always reflect the true market value regardless of who the buyers and sellers are. The SISA anticipates and allows for some investment transactions between people who are related by stating that if the parties are not at arm’s length, then they must act as though they are or on terms that do not disadvantage the SMSF.
I am often asked by trustees as to who does the valuation and how do they know whether the purchase price is based on a realistic market value?
The ATO would not normally question the value of assets in general when dealings are between unrelated parties. However, if the asset that is acquired by the SMSF represents a significant portion of the SMSF’s assets’ value then I would recommend the trustees use a qualified independent valuer to value the asset.
While valuations of assets can be conducted by a licenced valuer they can also be conducted by a person without formal qualifications such as a trustee. Whoever conducts the valuation needs to ensure that they are objective, have supportive data to support the valuation, and can show that the valuation is conducted in good faith, as a result of a reasoned and rational process and supported and justified to a third party such as the SMSF auditor or the ATO.
If the trustee is conducting the valuation themselves, they must ensure that their valuation is well supported as they are more likely to be challenged by the ATO than those valuations prepared by an independent or qualified valuer. Trustees should ensure they keep the appropriate records to support how the valuation of an asset was determined.
A common error made by SMSF trustees when valuing real property is comparing it to properties that have been listed on the real estate market. The trustees should value a property by comparing it to properties that have been sold in the last three to six months, in the area within 1 km of the property purchased, and similar in size and quality. Properties listed on the market do not have an agreed price and are only an indication of what the seller is willing to sell for.
The third area of the superannuation law in relation to investments is the duties and obligations of an SMSF trustee.
SMSF trustees’ duties and obligations are outlined in section 52B of the SISA. These duties are referred to as “trustee covenants” and are deemed to be in all SMSF trust deeds regardless of whether they actually appear in it. The covenants relevant to investments are:
- to keep assets of the SMSF separate from assets held personally by trustees, and;
- to formulate and develop an investment strategy that has regard to the SMSF’s circumstances.
Because the above two covenants are the ones that SMSF trustees have problems complying with, further laws were introduced into the SISA effective from 1 July 2012 that requires:
- trustees to provide evidence that demonstrate assets are kept separate, and;
- trustees to ensure that all investment decisions are made in accordance with the SMSF’s investment strategy and that the investment strategy is regularly reviewed.
Where ownership of assets is not clearly identified as belonging to the SMSF, it may cause problems in situations where either individual members of the SMSF or the related company acting as the corporate trustee of the SMSF goes bankrupt or in receivership.
Having a documented investment strategy demonstrates to the ATO that all investment decisions are made in accordance with the investment strategy. Although the SISA does not specifically state that an investment strategy must be in writing, the superannuation law (section 55(5) of the SISA) does provide a defence to SMSF trustees against an action for loss or damage suffered as a result of making an investment, if the trustees can prove that the investment was made in accordance with an investment strategy formulated for their SMSF.
Paying cash or using borrowed money to acquire an asset
If there is enough money in the SMSF to pay for the asset in “cash” then it is a straight forward transaction. As long as the money comes directly from the SMSF’s bank account, it is proof that it is being acquired by the SMSF in the event that ownership of the asset cannot be registered in the name of the SMSF.
Sometimes trustees may encounter situations where they may have to pay for the asset directly from their own personal finances, or place a deposit on the asset personally to secure the asset for purchase. They then later claim the money back from the SMSF. This is okay as long as there is documentary proof of the transaction, a written statement (perhaps in the trustees’ minutes) explaining the situation, and most importantly the purchase money is reimbursed by the SMSF immediately.
If, however, an SMSF needs to borrow to acquire an asset then it will not be a straight forward transaction. The subject of borrowings by an SMSF to acquire an asset which is referred under the superannuation law as “Limited Recourse Borrowing Arrangement” (LRBA) is a complex area of the law that needs careful planning and attention.
In brief under a LRBA you will:
- need to establish a separate trust (holding trust/bare trust);
- the trustee of the holding trust cannot be the same trustee as the SMSF;
- the asset acquired can only be a single acquirable asset;
- the money borrowed can only be used for repairs and maintenance and not for improvement, and;
- once the loan is fully repaid, the asset will need to be transferred from the holding trustee to the SMSF trustee.
So to summarise the acquisition requirement, an SMSF can acquire any type of assets from an unrelated party as long as:
- The purpose of the investment does not conflict with the sole purpose test and complies with the rules in relation to the acquisition of collectable and personal use assets.
- The purchase price paid on the asset is at market value and the transaction is conducted at arm’s length.
- The asset is in accordance with the SMSF’s investment strategy and is clearly kept separate from the member’s personal assets.
If an SMSF requires borrowing to acquire the asset the transaction and loan is structured correctly.
This article was prepared by Monica Rule. Monica is the author of “The Self Managed Super Handbook – Superannuation Law for Self Managed Superannuation Funds in plain English”