The Rules of the SMSF Game
The Rules of the SMSF Game
Running an SMSF is similar to playing a sport, such as Aussie rules, rugby, cricket or soccer, you need to know the rules. If trustees do not understand the rules of the game of superannuation they are putting themselves and their superannuation at risk.
Just as it would be foolish to play Aussie rules and not know you can’t run with the ball without bouncing it, it is just as foolish for trustees of an SMSF to not know what the rules are. It is these rules that dictate what their duties and responsibilities are and, when they are not broken, confirm their eligibility for the tax concessions available to complying super funds.
There is another similarity between playing a sport and being the trustee of an SMSF. Breaching the rules brings different levels of penalty, depending on the seriousness of the breach.
In soccer there are basically three levels of penalty. There are those for playing infringements that result in a free kick, such as being found offside. In addition there are the more serious breaches that can result in a yellow card or a red card.
Where a player receives a yellow card, for such things as persistent breaking of the rules or unsporting behaviour, the player is warned and a free kick is awarded. If a player gets two yellow cards in a game they are sent off. A player who commits a serious breach of the rules, such as violent conduct or spitting at someone, is sent off immediately. This is a red card.
Unlike soccer where there is only one set of rules relating to the game, in superannuation there are two sets of rules that a trustee of an SMSF must adhere to. There are the taxation rules and the superannuation rules detailed in the SIS legislation.
The attitude of the ATO changes, and the severity of the penalty increases, depending on how serious the breach of the regulations are.
The factors taken into account by the ATO when imposing higher penalties on trustees of an SMSF include when they have:
- failed to make a reasonable effort to discharge their duties
- repeatedly breached regulations
- knowingly accessed SMSF money prior to retirement
- deliberately set out to avoid their obligations
- refused to take recommended corrective action.
In the first two instances the ATO starts the process with its equivalent of a yellow card. This can be in the form of requiring trustees to accept a written undertaking that sets out the required actions for the trustees to deal with the breach. In some cases, depending on the severity of the breach, fines or other penalties can also be imposed.
Where trustees’ actions are deliberate and more serious, such as the last two instances listed above, they can receive a red card from the ATO. This is understandable, if trustees get to this position they are effectively guilty of spitting in the eye of the ATO.
The heavier penalties imposed by the ATO include:
- disqualifying a trustee or trustees
- removing a trustee
- freezing a fund’s assets
- the imposition of substantial fines
- declaring the fund to be non-complying
- prosecuting the trustees for breaking the law and jailing them for up to five years.
Trustees of SMSFs should not be complacent and think that the ATO will never impose the harsher penalties at its disposal. Recent results from compliance activities have shown more funds than ever are being made non-complying. When this occurs 47% of the accumulated assets of the fund, and the ongoing income of the fund, are taken in penalty taxes.
An example of the disastrous effect of a fund being made non-complying is the Kelly super fund that purchased a residential property from its members. The trustees, Ned and Kate, then rented the property to their daughter for a market rent. The fund had a total value of $1,000,000, including the value of the property, and income of $20,000.
Purchasing residential property from members and related parties is banned, as is renting residential property to family and related parties. The ATO required Ned and Kate to sell the property to fix the breach but they ignored the requests and their fund was made non-complying.
As a result the fund received a tax bill for $479,400, made up of 47% of the value of the fund and 47% of the income. Ned and Kate were forced to sell the property to pay the tax bill.
The New Penalty Regime
A major overhaul of the penalty regime applying to SMSFs was meant to have occurred with the introduction of a new penalty system from July 1, 2013. The legislation was eventually passed and applies to contraventions and breaches by trustees from July 1, 2014. The new penalty system gives the Commissioner the power to:
- impose administrative penalties without reference to a court,
- require trustees to take specific action to correct breaches, and
- require trustees to undertake education activities.
Under the new penalty regime fines will be imposed on either the individual trustees or the directors of the trustee company rather than the fund itself. In addition the legislation specifies that penalties imposed on individuals or directors cannot be reimbursed by the SMSF.
Administrative penalties will not be imposed for all breaches of the superannuation regulations, but will only apply to 17 breaches specified by the new legislation. The fines are applied on a penalty unit basis that range from five penalty units up to 60 penalty units. Each penalty unit has a value of $180 meaning fines will range from $900 up to $10,800.
There are only three breaches where the higher fine will be imposed. They relate to the ban on super funds lending to members, the restriction on a fund borrowing money other than exempted under the SIS Act, such as the limited recourse borrowing arrangements, and for breaches of the in-house asset rules. The smaller fines are imposed for more administrative breaches such as failing to sign required documentation.
If past history is any guide the fines will only be imposed when trustees of an SMSF do not comply either with a rectification direction or an education direction given by the Commissioner.
Rectification directions will specify actions that must be taken by the trustees of an SMSF to fix a breach of the regulations. A time limit will be placed on when the rectification must be completed by and trustees will be required to provide evidence of the actions having been taken.
For a complete list of the 17 regulations and fines click here.
Where trustees demonstrate that they do not have a proper understanding of the superannuation and SMSF regulations they will be directed to undertake a course of education within a specified time frame.
After the completion of the education trustees will need to confirm that they understand their obligations and duties by signing or re-signing the SMSF trustee declaration form. SMSF’s will be banned from reimbursing trustees for the cost of undertaking education courses.
Tax Office Penalty Table for Trustees
Provision of this Act
|1||Subsection 34(1) complying with applicable prescribed operating standards||20 penalty units|
|2||Section 35B Preparing specified accounting statements||10 penalty units|
|3||Subsection 65(1) Not provide financial assistance to members||60 penalty units|
|4||Subsection 67(1) Ban on borrowing||60 penalty units|
|5||Subsection 84(1) In-house asset rules||60 penalty units|
|6||Subsection 103(1) Retain minutes and records for individual trustees||10 penalty units|
|7||Subsection 103(2) Retain minutes and records for Corporate trustees||10 penalty units|
|8||Subsection 103(2A) Retain copy of elections||10 penalty units|
|9||Subsection 104(1) Keep records of changes of trustees||10 penalty units|
|10||Subsection 104A(2) SMSF trustees duties declaration||10 penalty units|
|11||Subsection 105(1) Retain member’s benefit reports||10 penalty units|
|12||Subsection 106(1) Notify ATO of significant events||60 penalty units|
|13||Subsection 106A(1) Advise ATO of change of status||20 penalty units|
|14||Subsection 124(1)Appoint investment managers in writing||5 penalty units|
|15||Subsection 160(4) complying with rectification directions||5 penalty units|
|16||Subsection 254(1) Provide information to regulator||5 penalty units|
|17||Subsection 347A(5) Complete survey forms and comply with education direction.||5 penalty units|
Each penalty unit is $180 in value.
How to Avoid Penalties
To ensure that their super fund is not put at risk of being penalised trustees should:
- make sure they understand their responsibilities when first becoming trustees by reading the information booklets issued by the ATO, and of course becoming a member of this site
- ask their fund’s accountant or auditor for help and guidance when they are unsure of something
- either put in place systems and financial records that provide an up-to-date picture of what the fund is doing on a regular basis, or have the accountant process their fund’s financial information before the end of June to detect any problems before the financial year ends
- cooperate at all times with the fund’s accountant and the auditor and be guided by what they say
- immediately attempt to fix any problems identified by the fund’s auditor or the ATO by taking the action recommended.
No matter how tough the financial situation gets for a member of an SMSF, unless they have met a condition of release, trustees should never be tempted to use the super fund’s assets to help a member. The cost of losing 47% of the fund and 47% on the amount paid out incorrectly is just too great.
n addition to there being two sets of rules there are also two referees. They are the auditor of the SMSF, who acts a bit like the match referee, and then there is the ATO that is the governing body interpreting the rules and imposing the penalties.
On a yearly basis the financial statements of an SMSF must be audited. An auditor reviews the accounts and operations of the SMSF. Any breaches of the rules discovered must be reported to the trustees, while some specified breaches and breaches repeated in later years must be reported to the ATO.
The ATO have produced a list as a part of the auditor contravention report to guide trustees on the various rules that if breached will result in their SMSF being reported to them. For this list click
Auditor Contravention Report
Section or Regulation
|S17A||The fund must meet the definition of an SMSF.|
|S35A||The trustees must keep and maintain accounting records for a minimum of five years.|
|S35B||The trustees must prepare and maintain proper accounting records.|
|S35C(2)||The trustees must provide the auditor with the necessary documents to complete the audit in a timely
and professional manner; and within 14 days of a written request from the auditor.
|S52(2)(d)||The assets of the SMSF must be held separately from any assets held by the trustee personally or by a
standard employer sponsor or an associate of the standard employer.
|S52 (2)(e)||The trustee must not enter into a contract that would prevent/hinder them from exercising the powers
of a trustee.
|S62||The fund must be maintained for the sole purpose of providing benefits to fund members upon their
retirement, or upon reaching a prescribed age, or to the dependents in the case of a member’s death
|S65||The trustees must not loan monies or provide financial assistance to any member or relative at any time
during the financial year.
|S66||The trustees must not acquire any assets (not listed as an exemption) from any member or related party
of the fund.
|S67||The trustees of the fund must not borrow any money or maintain an existing borrowing (not listed as an exemption).|
|S67A-67B||Limited recourse borrowing arrangements.|
|S69-71E||Outline of the in-house asset rules that trustees must follow. (These relate to transactions of any kind
with a related party of the fund.)
|S73-75||Outline of the manner in which in-house assets must be valued by trustees (arms length market value).|
|S80-85||The trustees must comply with the in-house asset rules.|
|S103||The trustees must keep minutes of all meetings and retain the minutes for a minimum of 10 years.|
|S104A||Trustees who became a trustee on or after 1 July 2007 must sign and retain a trustee declaration.|
|S109||All investment transactions must be made and maintained at arms length – ie purchase, sale price and
income from an asset reflects a true market value/rate of return.
|S126K||A disqualified person cannot be a trustee, investment manager or custodian of a superannuation fund.|
|Sub Reg 1.06 (9A)||Pension payments must be made at least annually and must be at least the amount calculated under
clause 2 of Schedule 7.
|Reg 4.09||Trustees must have an investment strategy for the fund.|
|Reg 5.03||Investment returns must be allocated to members in a manner that is fair and reasonable.|
|Reg 5.08||Member benefits must be maintained in the fund until transferred or cashed out in a permitted fashion.|
|Reg 6.17||Payments must be made in accordance with Part 6 of the regulations and be permitted by the trust deed.|
|Reg 7.04||Contributions must be accepted in accordance with the applicable rules for the year being audited.|
|Reg 13.12||Trustees must not recognise an assignment of a super interest of a member or beneficiary.|
|Reg 13.13||Trustees must not recognise a charge over or in relation to a member’s benefits.|
|Reg 13.14||Trustees must not give a charge over, or in relation to, an asset of the fund.|
|Reg 13.18AA||Investments in collectables and personal use assets must be maintained in accordance with prescribed
Under the new penalty regime trustees can be fined from $900 up to $10,800.
The ATO does not rely only on SMSF auditors to advise when trustees break the rules. It also has a compliance section that conducts audits and other compliance activities for funds regarded as high risk. The ATO conducts over 10,000 audits and reviews of SMSFs each year.
How the ATO deals with breaches of the rules
When the ATO took over regulation of SMSFs in 1999 it focused on an education role for trustees. In this aspect the ATO acted more like a coach than an umpire. But a few years ago the Commissioner of Taxation announced that the ATO was reducing its nice guy education role and taking up more seriously its enforcer and compliance duties. As a result increasingly the ATO is handing out penalties rather than giving advice.
Although the ATO is taking its compliance role more seriously, trustees of SMSFs should not be too worried if they make innocent mistakes. Where the ATO finds trustees are genuinely making an effort to play by the rules, it will work with them to help rectify the breaches. This means the ATO still acts at times more like a coach than an umpire.
In actual fact in the majority of cases it will be the SMSF’s auditor that will find where trustees have breached the regulations. In this situation the auditor will assist the trustees, together with the fund’s accountant, to rectify the breaches.
The Main Duties and Responsibilities of Trustees
ust as there are several levels of penalties that can be imposed for breaches of the regulations, there are different levels of responsibilities and duties for trustees of an SMSF.
It is also important to remember that, although the ATO is the regulator and there are tax laws that must be complied with, there are also the regualtions in the SIS Act that govern the operation of a superannuation fund.
The sole purpose test
In the Ten Commandments, after you get past those relating to making sure God is worshipped exclusively and properly, the most important commandment is:
Thou shall not kill.
In superannuation terms the top commandment is contained in a very lengthy section under the heading ‘Sole purpose test’. To see how the legislators set out this test in Section 62 of the SIS Act click here.
In simple terms the trustees of an SMSF should ensure all transactions have the sole purpose of providing retirement benefits to its members and/or their dependants after reaching a specified age (preservation/retirement age), after the death of a member or after a member becomes ill or injured. This benefit can be in the form of an income stream or a lump sum, as long as the fund’s deed allows these types of benefits.
The final item of the section is what you would expect in any well-drafted legislation. This enables governments to allow for other ways that a person can access superannuation. Two recent examples of this are transition to retirement pensions and the terminal illness condition of release.
This sole purpose test should in fact make it easier for all trustees of an SMSF to make sure they do the right thing. If a trustee is thinking of taking an action that cannot be linked to providing a retirement or death benefit, it is more than likely not allowable. Members of a super fund are banned under this key principle from getting an immediate benefit from their superannuation.
The trust deed
If the sole purpose test is the first commandment for trustees of an SMSF to follow, the trust deed of the SMSF is their bible. If trustees are ever unsure of whether they can do something, or they are not sure of how to do something, they should refer to the trust deed for guidance. This is the document that details all of their duties, responsibilities, and how the fund should be operated.
Other duties and responsibilities
The other duties of trustees relate to the operation of an SMSF and deal with the main activities of the trustees of an SMSF. There are the duties and rules that relate to investing and the paying of benefits, and also those that deal with administration requirements.
These include keeping all relevant and required records and documents, such as minutes for ten years and accounting records for at least five years, plus lodging all required returns with the relevant authorities within the stated lodgement deadlines.
Trustees have an obligation to only accept contributions from people entitled to make them within the limits laid down. These limits not only relate to the amounts that can be contributed but also to when they can be made.
The main restrictions on when a super fund can receive contributions are for people 65 and older. Once someone turns 65 they must satisfy the work test for contributions to be made on their behalf. Once a person turns 75 trustees of a super fund can receive no further contributions for that member, unless they are mandated employer super guarantee contributions.
The limits placed on the amounts received by a trustee on behalf of members cover (deductible) concessional contributions and (undeducted) non-concessional contributions.
These limits cover contributions made in cash and also those made in specie by transferring assets into a super fund.
Section 62 Sole Purpose Test
Each trustee of a regulated superannuation fund must ensure that the fund is maintained solely:
(a) for one or more of the following purposes (the core purposes):
(i) the provision of benefits for each member of the fund on or after the member’s retirement from any business, trade, profession, vocation, calling, occupation or employment in which the member was engaged (whether the member’s retirement occurred before, or occurred after, the member joined the fund);
(ii) the provision of benefits for each member of the fund on or after the member’s attainment of an age not less than the age specified in the regulations;
(iii) the provision of benefits for each member of the fund on or after whichever is the earlier of:
(A) the member’s retirement from any business, trade, profession, vocation, calling, occupation or employment in which the member was engaged; or
(B) the member’s attainment of an age not less than the age prescribed for the purposes of subparagraph (ii);
(iv) the provision of benefits in respect of each member of the fund on or after the member’s death, if:
(A) the death occurred before the member’s retirement from any business, trade, profession, vocation, calling, occupation or employment in which the member was engaged; and
(B) the benefits are provided to the member’s legal personal representative, to any or all of the member’s dependants, or to both;
(v) the provision of benefits in respect of each member of the fund on or after the member’s death, if:
(A) the death occurred before the member attained the age prescribed for the purposes of subparagraph (ii); and
(B) the benefits are provided to the member’s legal personal representative, to any or all of the member’s dependants, or to both; or
(b) for one or more of the core purposes and for one or more of the following purposes (the ancillary purposes):
(i) the provision of benefits for each member of the fund on or after the termination of the member’s employment with an employer who had, or any of whose associates had, at any time, contributed to the fund in relation to the member;
(ii) the provision of benefits for each member of the fund on or after the member’s cessation of work, if the work was for gain or reward in any business, trade, profession, vocation, calling, occupation or employment in which the member was engaged and the cessation is on account of ill health (whether physical or mental);
(iii) the provision of benefits in respect of each member of the fund on or after the member’s death, if:
(A) the death occurred after the member’s retirement from any business, trade, profession, vocation, calling, occupation or employment in which the member was engaged (whether the member’s retirement occurred before, or occurred after, the member joined the fund); and
(B) the benefits are provided to the member’s legal personal representative, to any or all of the member’s dependants, or to both;
(iv) the provision of benefits in respect of each member of the fund on or after the member’s death, if:
(A) the death occurred after the member attained the age prescribed for the purposes of subparagraph (a)(ii); and
(B) the benefits are provided to the member’s legal personal representative, to any or all of the member’s dependants, or to both;
(v) the provision of such other benefits as the Regulator approves in writing.
The restrictions on the investing activities of the trustees of SMSFs are the most numerous. This is because this is the area where most breaches can occur.
Trustees must take account of the following regulations when it comes to investing:
- Investment Strategy
Trustees of an SMSF must have an investment strategy in writing. It can be very general, such as stating broad limits on the different investment sectors the trustees can invest in, or it can be very specific.The main thing to understand is that the investment activities of the super fund must be able to be measured against and done in accordance with the strategy.
As a minimum the strategy should take account of the risk associated with an investment’s return. The strategy should also consider the activities of the SMSF and the point that the members are at.
In other words, the strategy must ensure there is sufficient liquidity in the investments to be able to pay all commitments, including tax, administration costs and benefits. As a part of this, trustees should take into account the importance of diversifying the SMSF’s investments over the various types of investments.
The investment policy regulations were updated in August 2012 so that the investment policy must be reviewed regularly. Many experts believe that this condition will be met if the investment policy is reviewed annually, or at other key times such as when a member is admitted to a fund or a pension is commenced. In addition the changes make it compulsory for trustees to consider the requirement of insurance for members.
- Investments must be made and maintained at arm’s-length
In most cases this requirement is not a problem as they are purchased from totally independent parties. Where investments are purchased from members this must be done on commercial and arm’s-length terms. In the limited circumstances that an investment is allowed to be used by a related party, such as commercial property, commercial rentals must be paid.This duty also requires trustees to keep the SMSF’s assets separate from their own. In addition the assets of the SMSF must show the trustee or trustee’s names on the ownership documents and preferably also the name of the SMSF.
- Investments cannot be purchased from related parties except in limited cases
The only exceptions to an SMSF purchasing investments from members are when they are publicly listed such as shares, widely held trusts such as unlisted property trusts, or when it is business real estate such as shops or offices. The only other exception is investments purchased under the 5% in-house assets rule.
- In-house assets cannot exceed 5% of the market value of the fund
Where investments, loans or other financial transactions involve members or related parties, their total value cannot exceed 5% of the total value of the SMSF. The values used for this test are the current market values and not the purchase costs. These investments are called ‘in-house assets’.Examples of in-house assets include:
- monies lent to related parties through a private company,
- a car owned by the SMSF leased to a member or related party,
- property owned by the SMSF leased to members or related party,
- artworks and other collectibles owned by the SMSF and kept in a member’s home.
In all of these cases of in-house assets their combined total cannot exceed 5% of the total market value of the SMSF. This means in most cases only SMSFs with very large member balances and total asset values can look at using the in-house assets rules.
- Investments must be valued at market value
Trustees of SMSFs must value the investments of the fund at market value each year. To help trustees of SMSFs with valuing investments the Tax Office have issued an information sheet ” Market valuation for tax purposes” that provides guidance for SMSFs.For many investments made by SMSFs there will be markets in place and establishing a value will be relatively easy. Listed shares can use the value shown on the last trading day of the financial year supported by published share tables. For managed funds the annual statement showing the value can be used.
The requirement to value investments at market value does not mean all investments must be valued by a valuer. In fact collectables and personal-use assets are the only investments that must be valued by a qualified independent valuer.
Where a property is owned by an SMSF the ATO does not even require a formal valuation by a registered valuer. Instead, in its information sheet the ATO states, ”the valuation may be undertaken by anyone as long it is based on objective and supportable data”.
The Tax Office even goes further by outlining the relevant factors and considerations to be considered in arriving at a market value. These include:
- The value of similar properties.
- The amount paid for a property in an arm’s-length transaction.
- Appraisals by an independent person.
- The cost of improvements since the property was last valued.
- Using net income yields for commercial properties.
In this situation the trustees must be able to provide evidence of the valuation process, such as a real estate agents appraisal, so the auditor of the fund can accept the value used.
The Tax Office is also taking a practical approach to how often a property needs to be valued. Unless there is an event that has affected the property since it was last valued, such as a big change in market conditions or a natural disaster, the property does not need to be valued each year.
The exceptions to this are where the fund’s trust deed requires annual asset valuations and where a fund has any pension members. In these cases all assets need to be appraised each year.
In the absence of these events, it is generally accepted a property only needs to be revalued every three years. It would be wise, however, for trustees to state as a part of the fund’s annual investment strategy, that in their opinion the value of properties had not materially increased since they were last valued.
Keeping Funds Separate
The trustees of an SMSF must keep the cash and investments of the fund separate from their own personal assets and any assets belonging to other entities or businesses they are associated with. This means a super fund must have bank accounts and investments that are not used for any purpose other than the activities of the SMSF.
To assist in satisfying this requirement trustees should ensure bank accounts, trading accounts and all asset acquisitions are noted as being acquired by the fund. This is extremely important where property is purchased and the titles office does not allow the super fund’s name to be noted on the title.
This duty is one that, despite the best intentions of the trustees of an SMSF, is often breached. This can be as a result of a trustee accidentally banking cash or cheques meant for the super fund into a private account, or it can be as a result of a mistake by an investment manager or bank crediting a deposit to a wrong account. When these mistakes are made and discovered they must be corrected as soon as possible.
As all of the investments in an SMSF must be in the name of the trustees as trustees of the fund, where the trustees are individuals it can be easy for mistakes to be made. One way of reducing the chance of this duty being breached is to have a company formed to act as trustee for the SMSF.
This does cost more in the setup stage of an SMSF but, where the company trustee name is very different from the names of the members, it reduces substantially the chance of this duty being innocently breached. It also means that when one on the members dies by having a company act as trustee the SMSF continues.
Payment of Benefits
Where an SMSF’s deed is silent on when benefits must be paid out there is only one situation where trustees are forced to pay benefits, and that is when a member dies. When this occurs the trustee must, as soon as practicable after the date probate is granted, pay out the deceased member’s benefits. In most cases these can be paid to a member’s estate or dependants.
Just because a member dies does not mean their benefits must be paid out. Where they are receiving a reversionary pension, and the reversionary pensioner is a dependant, no lump sum payment is made as the pension is paid to the reversionary pensioner. Trustees of an SMSF can also decide to pay death benefits to a dependant in the form of a death benefit pension.
For all voluntary cashing of benefits, in other words benefits requested to be paid by a member, depending on the type of benefit a condition of release must be met.
No financial assistance to members
Members of an SMSF, and/or their relatives, are unable to receive loans or other financial assistance from the fund. This ban also stops an SMSF allowing its investments to be used as security for a loan to a member or a member’s relatives.
Super Funds and Borrowing
As a general rule super funds are not allowed to borrow. The only times they can are:
- to pay any surcharge obligations the fund may have, provided the fund uses any cash reserves first, and provided the debt is less 10% of the total assets of the fund, and is only maintained for a period of up to 90 days
- to pay out benefits to a member if the loan is not for longer than 90 days and it does not exceed 10% of the market value of the super fund, and there are no other cash assets of the fund to make the benefit payment
- after exhausting the cash in the fund to pay for an investment, if the fund is experiencing unexpected short-term cash flow problems and the loan is not for longer than seven days and does not exceed 10% of the market value of the super fund, a loan to pay for an investment after it was purchased
- when a super fund meets the conditions set out in the Act relating to limited recourse borrowing arrangements.
At the heart of the rule is the necessity to protect the members’ funds from attack. Without this rule, members of SMSFs and also large industry and commercial funds, would face the risk of their retirement savings being wiped out by unwise borrowings.
Before the law changed on 24 September 2007, super funds could invest in managed funds that had borrowings. In this case the only thing at risk was the investment rather than the entire super fund.
The new legislation that applied from September 2007 did not change the long-term rule that prohibits super funds from borrowing. It did however introduce an exception to this rule under the following very tight conditions:
- The borrowing must be related to the purchase of an asset that the trustee of the super fund is allowed to purchase.
- The asset acquired is to be held on trust so that the fund receives a beneficial interest in the asset.
- The legal ownership of the asset can pass to the super fund after it has made one or more payments or instalments.
- The loan taken out by the trustee of the super fund must be a non-recourse loan, which means the lender only has a claim on the asset purchased and not the other assets of the super fund.
Means that the asset purchased must fit within the investment strategy of the super fund and it cannot be one that is prohibited by law. For example, this amendment does not alter the fact that, except for a few limited exceptions such as business property, a super fund cannot buy assets from members.
Thus this ability to borrow does not mean a super fund can borrow to purchase a residential property from a member, but it does mean a super fund can borrow to purchase a business property from a member or a residential property from a non-associated entity or individual.
Requires the asset purchased with borrowings to be held by a custodian. This borrowing or instalment trust requires a trustee, preferably a company, to be shown as the legal owner of the asset with the super fund being the ultimate beneficial owner.
Requires the super fund to make one or more payments before it can become the legal owner of the asset. In practice what this means is that a trust must be formed which purchases the asset. Once all payments have been made by the super fund it becomes the legal owner of the asset.
For the borrowing to be a non-recourse loan — this means that, unlike other loans where lenders require guarantees from everybody associated with the borrowing, the super fund cannot be at risk if there is a default on the loan. Ultimately this means the financial institution advancing the funds can only use the asset purchased as security for the loan. Any guarantees provided by members to assist with the loan being approved, must also be limited to the asset the fund is acquiring with the debt.
ASIC recently said it was worried about the number of SMSFs investing in residential real estate. In many cases developers of the residential real estate, and or their commission driven sales people, are getting people with very little super to set up an SMSF so they could sell their properties. If someone suggests setting up an SMSF just to buy a property get independent professional advice before doing anything.
Trustees of self managed super funds should be very careful before buying assets under this exemption. Since the introduction of the new legislation a new industry has grown up offering documentation services and funding to super funds. The old legal tenet of ‘let the buyer beware’ is applicable.
Costs quoted for drawing up the required documentation range from as little as $125 to more than $5,000. Before deciding on who you will get to prepare the documentation, you should check with the financial institution providing the funds. It will be them that decides what sort of warrant trust is needed.
In addition, the interest rates payable on non-recourse loans can range from a very reasonable rate up to what could be classed as almost loan-shark rates. Some providers of finance for geared property purchases offer a bundled product that includes the finance and the documentation.
In these cases trustees can find they are not only paying an exorbitantly high interest rate but paying more than they need to for the documentation. When the service is being offered by a developer they can also pay an inflated price for the property. Trustees will need to do their homework, compare what is available and use the borrowing capacity wisely.
Trustees should also exercise caution when it comes to the amount being borrowed to purchase the asset. Unless they are happy to pay inflated interest rates, trustees of a super fund should limit the borrowing to no more than 60% of the cost of the asset purchased. By limiting the borrowing the super fund will also have a reduced risk of being put under financial pressure if asset values and incomes reduce.
Auditing an SMSF
One of the first jobs trustees of an SMSF must do is appoint an approved auditor for the fund. Approved auditors must:
- Have completed a tertiary accounting qualification involving at least three years of study that included an audit component or studied auditing after having completed the tertiary study with a professional organisation.
- Be a fit and proper person.
- Hold appropriate professional indemnity insurance.
- Have at least 300 hours of auditing SMSFs in the three years prior to applying for registration.
- Have passed a competency test.
Transitional arrangements allow current SMSF auditors to apply for registration.
An SMSF audit must be conducted in accordance with the auditing standards. These standards apply equally to the audit of publicly listed companies as they do to SMSFs.
This often means the level of work required to meet the standards for an SMSF creates conflict and extra work for the auditor and extra cost for the trustees of the fund. These standards also do not specify the critical areas that SMSF auditors should concentrate on, such as accessing super incorrectly or purchasing investments barred by the SIS legislation.
The ATO has over the years been toughening its approach to the level of independence that auditors must have when auditing an SMSF. As a result, the auditor of an SMSF must effectively apply the same standards as the auditor of, for example, BHP-Billiton. In some cases this is justified as some auditors have not reported blatant breaches of the regulations and allowed superannuation to be used by members in contravention of the sole purpose test.
The ATO has highlighted what it regards as being the three biggest threats to the independence of an auditor. These are:
- Self review. This threat can occur where the person who prepares the fund’s accounts and financial statements also conducts the audit. This can often be the case where the accountant engaged by the trustees of the SMSF is a sole operator. Often accountants in this situation try to save their clients money by doing everything.
If the auditor maintains professionalism and conducts the audit properly this should not be a problem. But if auditors turn a blind eye to mistakes, for whatever reason, they are jeopardising professional integrity and putting at risk the compliance status of the fund.
- Self interest. This threat mainly relates to when the auditor not only does the audit but also provides investment advice to the trustees. The concern is that, if the adviser could lose revenue by conducting the audit properly, they may be tempted to let breaches of the investment regulations go.
- Intimidation. This threat can really be regarded as part of the first two. The concern is that an auditor may not complete the audit properly if the trustees of the fund threaten to stop using his or her services if the auditor reports a breach of the regulations.
In the end every accountant that conducts an audit of a super fund must apply the appropriate level of professionalism to the task. But the sad truth is, as some of our more celebrated corporate collapses have shown in the past, even auditors of publicly listed companies act unprofessionally. Hopefully the ATO will not judge the independence of auditors on perceived threats but more on the way an audit is conducted.
Reporting of Contraventions by Auditors
Auditors of SMSFs have always had to notify the trustees of any breaches of the SIS Act or other regulations they find. Since 1 July 2007 an auditor must report every contravention of the listed sections or regulations by trustees of a fund in its first 15 months of operation, where any of the contraventions exceed $2,000 in value.
The ATO has stated it wants all contraventions reported as an information-gathering exercise to gain a better understanding of how trustees are discharging their duties. The ATO will use this information to better target educational and enforcement activities for SMSFs.
The Contravention Report
In addition to reporting breaches in the first 15 months the ATO has a form listing the mistakes made by trustees of an SMSF that must be reported by auditors of super funds. This report applies to all audits carried out.
The contravention report is an indication of the tougher stance the ATO is taking in performing its role as the regulator of SMSFs, and should provide a warning to trustees of SMSFs to discharge their duties properly. The form also incorporates the new requirement that all breaches of the regulations must be reported by auditors of SMSFs in their first 15 months of operation.
The contravention report is set out as seven questions that, when the answer is yes, the breach of the regulations must be reported. The way the questions are organised, and how they are described, provides a guide to trustees of SMSFs on how they can best avoid coming under the microscope of the ATO.
To see the questions click here.
Rules and regulations covered by the report
The instruction guide issued to auditors on how to complete the contravention report lists 20 reportable regulations and sections of the Act covered by these tests. They include:
- the sole purpose test
- failing to separate super assets from personal assets
- providing financial benefits to members or their relatives
- purchasing assets from members and/or related parties
- the in-house asset rules
- borrowings by the fund
- keeping proper records and minutes
- investments to be maintained on an arm’s-length basis
- having an investment strategy
- acceptance of contributions
- restrictions on the payment of benefits to members
- charges over the assets of the fund.
These rules should be understood by trustees and kept in mind every time they are performing their duties.
Seven Questions in a Contravention Report
Test 1: Fund definition test
Did the fund fail to meet the definition of an SMSF?
If yes the breach must be reported, if no go to question 2.
If a fund fails this test there are major problems. To recap, for a fund to pass the definition of an SMSF it cannot have more than four members, all members must be trustees or directors of a trustee company, no member can be an employee of another member unless they are relatives, and trustees cannot be paid for performing their duties as trustees.
Test 2: New fund test
At the end of the financial year is the SMSF less than 15 months old?
If yes report all identified contraventions of the sections and regulations listed on table 1 (not included here), if no go to test 3.
This is the new requirement that commenced for funds set up after 1 July 2007 and, as long as trustees learn from and don’t repeat their mistakes, the ramifications for the fund should not be too serious.
Test 3: Trustee behaviour test
Has the trustee/s previously received advice of a contravention that they breached again?
If no go to test 4, if yes report identified contraventions and go to test 4.
Test 4: Trustee behaviour test
Is there an identified contravention from a previous year that has not been rectified at the time the audit is being conducted?
If no go to test 5, if yes report identified contraventions and go to test 5
Where trustees fail these tests they should really reconsider whether an SMSF is the best fund for them.
This type of behaviour would be sending a clear message to the ATO that these trustees are not really interested in playing the SMSF game by the rules. If these tests were not passed two years in a row the ATO could very well go straight to a red card penalty with the trustees suffering the consequences.
Test 5: Trustee behaviour test
Did the trustees fail to meet a statutory time period by more than 14 days?
If no go to test 6, if yes report identified contraventions and go to test 6.
This test is the one that many trustees breach because of the low priority placed on providing documentation to auditors in a timely manner. Under the new contravention reporting regime every time a trustee fails to meet a deadline by more than 14 days it must be reported. Unless trustees want to face unnecessary attention from the ATO they should take all requests for information from the auditors seriously.
Test 6: Financial threshold test
Was the total value of all contraventions greater than 5 % of the total value of the fund’s assets?
If no go to test 7, if yes report identified contraventions and go to test 7.
Test 7: Financial threshold test
Was the total value of all contraventions greater than $30,000?
If yes report identified contraventions and, also if no, report additional information in accordance with auditing and assurance standards and your professional judgement.
The inclusion of value limits on breaches of the regulations is a welcome refinement of the contraventions reporting requirements. Without the $30,000 total value limit, and the 5% of total asset value limit, every simple administration error would have had to be reported to the ATO.
It should be remembered that where a breach of the sections or regulations are below these thresholds they still must be reported to the trustees by the auditor. If the trustees ignore the breach and commit it again they will be caught the following year by tests 3 and 4.