SMSFs: How to comply with investment restrictions

There are some key investment restrictions that apply to SMSFs.

"Sole", "core" and "ancillary" purposes explained.

One of the advantages to running your self-managed superannuation fund (SMSF) is you are largely free to invest in anything – shares, fixed interest, property, commodities, artwork, vintage cars or even fine wine – provided the investments are consistent with your fund’s investment strategy.

There are some rules, of course, for example, in relation to the storage of collectables. In addition to these rules, there is one important proviso to consider: the sole purpose test.
The sole purpose test

The sole purpose test relates to a superannuation fund’s “purpose” – that is, to provide for your retirement – and helps explain some of the key investment restrictions that apply to SMSFs. These restrictions relate to how the investment is being transacted and with whom, rather than the type of asset being acquired.

The test requires an SMSF to be maintained for the single purpose of providing its members with retirement benefits. To satisfy the sole purpose test, the fund must be maintained for one or more “core purposes”, and it may also be maintained for one or more “ancillary purposes”.

The core purposes are to:
•    provide benefits for members after their retirement
•    provide benefits for members after reaching the prescribed age (currently 65)
•    provide benefits to the legal personal representative and/or dependants of a member following their death, provided the death occurred before the member retired or reached 65 years old

The ancillary purposes are to:
•    provide benefits for members on or after termination of employment
•    provide benefits for members on or after they cease work due to ill health
•    provide benefits to the legal personal representative and/or dependants of a member following the member’s death, where the death occurs after retirement or after reaching 65 years old

Breaking the sole purpose test is considered serious, and may lead to trustees facing civil and criminal penalties. The fund may also lose its complying status.

The sole purpose test forms the basis of a number of investment restrictions. For example, your SMSF cannot own your holiday house because there is a risk that your SMSF may not receive adequate financial compensation for this asset due to your personal use of it and hence the fund would not be operating solely to provide retirement benefits to its members. On the other hand, your fund is allowed to own an investment property that is rented out and not used by yourself or a related party.

Let’s review the four key investment restrictions.

1. Your fund cannot lend money to a member or a member’s relative

Your SMSF is not allowed to provide any form of financial assistance, including loans, to a member of the SMSF or a relative of the member. There are no exceptions to this prohibition.

A relative is a:
•    parent
•    grandparent
•    sibling
•    uncle, aunt, nephew, niece
•    child or adopted child of the member or their spouse
•    the spouse of the member or of any individual outlined above

2. Your SMSF can only borrow money in limited circumstances

Your SMSF cannot borrow money, except in the following circumstances:

•    to fund a payment to a beneficiary or pay a surcharge liability – in which case, the borrowing can’t exceed 90 days and cannot be more than 10 per cent of the fund’s total assets
•    to cover the settlement of securities transactions, and then only up to seven days and again, not more than 10 per cent of your fund’s total assets
•    to acquire an asset under a Limited Recourse Borrowing Arrangement (LRBA)

With an LRBA, the lender’s only recourse is to the asset that is the subject of the loan. The lender has no claim on the other assets of the fund. Instalment warrants over shares are a form of LBRA, as are the super property loans currently being advertised by many of the banks.

3. Your SMSF cannot acquire an asset from a related party

Your fund cannot acquire an asset from a related party. This rules out your SMSF buying your investment property or holiday home.

The definition of a related party is broad and exhaustive and includes all the members of your fund and their relatives, the business partners of each member and the business partner’s spouse or child, and any trust or company controlled or influenced by a member.

There are, however, some exceptions. These are:

•    Listed securities – provided they are acquired at market value. Listed securities are shares, bonds, etc. quoted on the ASX or on approved international stock exchanges.
•    Business real property – this is property used wholly and exclusively in one or more businesses. A single residential rental property, such as an investment property or holiday home, will not qualify as  business real property.
•    Investments in a widely held trust, such as a managed fund.
•    Investments in an in-house asset of the fund, provided that acquisition does not cause the SMSF to breach the 5 per cent cap (see point 4).

The acquisition must be at market value (in the case of listed investments) or on an arm’s length basis (that is, on commercial terms), and be undertaken as part of a properly formulated investment strategy. If the acquisition is at “no cost” as an in-specie contribution – that is, when you transfer an asset, like shares or property – then the asset should be recorded at the market value as at the date of transfer.

4. There is a five per cent cap on in-house assets

An “in-house asset” is a loan to, or an investment in, a related party of your fund or a related trust of the fund. For example, if Peter Jones is a trustee of the Jones Family Superannuation Fund, a loan by his SMSF to a company controlled by Peter Jones would be considered to be an in-house asset. An in-house asset also includes an asset of the fund that is leased to a related party.

The investment restriction for SMSFs is not a total prohibition, but rather a rule that says that the amount of an SMSF’s in-house assets must not exceed 5 per cent of the market value of its total assets. This rule is tested at the end of each financial year and each time an asset is acquired, so look out for fluctuations in the value of your fund.

The key exemption from this rule is the “business real property” exemption. This exemption facilitates a common practice whereby the SMSF owns their business premises, and the premises are then leased to the member or the member’s company on an arm’s length basis.

Conclusion

The major investment restrictions originate from the application of the sole purpose test and the government’s concern that some trustees might not administer their SMSF in accordance with the purpose for which is has been established – that is, to specifically fund their retirement. Contravention of any of these restrictions can carry severe penalties. If you are contemplating an unusual transaction, ask yourself whether it meets the sole purpose test. That will usually tell you whether it is permissible or not.

Paul Rickard was the founding managing director and CEO of CommSec.


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