Chapter 03 – Self-managed super funds (SMSFs)

Dover encourages their advisers to recommend SMSFs, when appropriate, to clients.

The basics of Self Managed Superannuation

What is a SMSF?

A SMSF is a special type of trust. It is special because the trust assets are held and managed by a trustee for the purpose of providing retirement income and other benefits to members. This means it qualifies for special income tax concessions under the tax law.

A SMSF is a super fund with less than five members that is managed by its members. SMSFs are also known as DIY funds. The Australian Taxation Office (“the ATO”) is the main SMSF regulator, and has the responsibility of overseeing SMSFs in Australia.

The members, or a company owned and controlled by the members, act as the trustees. The trustees control the SMSF’s investments and are generally responsible for the SMSF’s administration and its compliance with the law.

A SMSF is controlled by a trust deed. The trust deed sets out the rules the SMSF has to follow. It also sets out the obligations and responsibilities of the people connected to the SMSF, ie the members and the trustees. The rules for paying contributions on retirement or death, investing assets, holding meetings, appointing trustees, paying benefits to members and the other matters affecting the SMSF are also found in the trust deed.

The three essential parts of a trust are present in a SMSF. These are:

  1. a trustee;
  2. trust property; and
  3. beneficiaries, in this case called “members”.

The trust deed must have special rules if the SMSF is to be a complying super fund and be eligible for tax concessions. However, it is the trustee’s year-to-year conduct that ultimately determines the SMSF’s eligibility for tax concessions.

To be a SMSF the fund must be a super fund and must also satisfy a number of conditions set out in section 17A of the SIS Act. These conditions are:

  1. the fund must have no more than four members;
  2. if the trustees of the fund are individual persons, each of them must be a trustee and if the trustee of the fund is a company, each member must be a director;
  3. the members are not in an employment relationship unless they are relatives;
  4. no trustee derives any benefit from providing services to the fund or for performing his/her/its duties as a trustee.

What is a member?

A person is said to be a “member” if the trustee holds benefits on trust for them. The role is analogous to a beneficiary of a family trust, and a unit holder of a unit trust. The member is entitled to receive benefits from the SMSF on the occurrence of certain specified events, such as reaching a certain age, or dying (in which case the benefits are paid to the member’s estate or dependants or a nominated person).

Most SMSFs only have two members. Often, these members are a couple, leading to the colloquial term ‘mum and dad’ funds. A minority will have members of another generation (i.e. children) as members too. It generally does not make sense for unrelated people to be members of the same SMSF. More commonly, two or more unrelated people will establish separate fund so as to keep their financial arrangements separate.

Why the limit on the number of members?

The number of members is limited to four so that the SMSF cannot become too big. This rationale is not perfect, as obviously it is possible for a one member fund to hold more member benefits than a four member fund. But it does make some sense. It also means that individual SMSFs do not become too big, and that the members stay in control.

Most of the consumer protection type rules in the law do not apply to SMSFs. The rule that members must be trustees means that members will automatically have access to financial information and other information about the fund, and so a further layer of protective regulation is not necessary. This simplifies the costs of running SMSFs and makes them more accessible and workable. Increasing the number of members beyond four members would run contrary to this policy, making SMSF less workable, more expensive and more difficult to run.

There is some sense in the rule being relaxed so there can be more than four members if they are all part of the same family. This “same surname” approach is discussed in the industry from time to time but there is nothing to suggest it will become law at present.

Single member funds

It is not possible for a person to be the trustee for himself or herself. This is because the necessary separation of equitable ownership and legal ownership, which is a fundamental to the concept of a trust, of which a SMSF is a sub-species, is missing.

This posed a problem for the legislature when section 17A of the SIS Act was being drafted: how can the all members be trustees rule be satisfied in the case of a single member fund? The solution was an exception to the rule which in effect says that in the case of a single member fund:

  1. a sole director/shareholder company can act as trustee, with the member as the sole director and shareholders (since this creates the necessary separation of equitable ownership and legal ownership); or
  2. another person can be a trustee provided that other person is a relative.

A “relative” is defined widely and goes as far as second cousins, and includes relatives by marriage or adoption, de-facto spouses, and ex-spouses. “Spouse” includes a same sex partner. There is some contention as to whether a special rule for single member funds is necessary. This is because the member’s dependants may have a contingent interest in the fund, and in that sense may be a beneficiary under the trust deed, and/or because a SMSF is a purpose trust, and may have future members. This contention is, however, completely academic as the law is very clear regarding who must be the trustee(s) for a single member fund.

Members who are also employees

A person cannot be a member of the same fund as his or her employer, unless they are related. This rule is intended to make sure that self-managed super funds do not become de-facto employer sponsored funds, but without the extensive consumer protection type rules afforded to employees in these funds.

What happens if a member/trustee dies?

This is controlled by sub-section 17A (3)(b) of the SIS Act. If a member dies the deceased member’s legal personal representative will become the trustee of the SMSF or the director of the company that is the trustee of the SMSF. The legal personal representative will remain a trustee, and hence the fund will remain a SMSF, from the date of death until the death benefits start to be paid. Once the death benefits begin to be paid the legal personal representative must cease to be a trustee or a director of a corporate trustee.

What happens if a member comes under a legal disability?

This is controlled by sub-section 17A(3)(c) of the SIS Act. If a member comes under a legal disability the disabled members’ legal personal representative will become the trustee of the SMSF or the director of the company that is the trustee of the SMSF for the duration of the disability.

What other laws are relevant to SMSFs?

SMSF trustees are subject to a wide range of laws. These include:

  1. the general law;
  2. trustee law, i.e. the special body of law developed over centuries that applies to trustees, including the various state Trustee Acts;
  3. rules that apply specifically to SMSFs, being the SIS Act; and
  4. the Tax Act. All of these laws must be complied with if the SMSF is to be eligible for tax concessions and the trustees are to avoid penalties under the SIS Act.

Who supervises SMSFs?

The Australian Taxation Office (“ATO”) is responsible for enforcing the SIS Act and other super laws as they apply to SMSFs.

If the SMSF’s deed is drafted properly and the trustees comply with the law, the SMSF will be eligible for tax concessions. These concessions can include a deduction for concessional contributions and concessional tax on the SMSF’s income. These tax concessions drive the SMSF’s enhanced investment performance. It is the tax concessions that make super such an attractive investment medium and allows it to outperform alternative investments.

Although theoretically onerous, trustees are normally able to satisfy these rules without any difficulty. The ATO is helpful, not obstructive and it is on the record as saying it will follow the standards set by its predecessor, the APRA. It is important not to overstate the risk of breaching the law. In most cases SMSFs run smoothly and difficulties are not encountered. Except for cases of extreme culpability, a SMSF that has inadvertently breached the super law will be deemed to have complied with the law by the Regulator. Where there is a minor breach of these rules, the Regulator generally uses its discretion to deem the SMSF to have complied with the rules.

How does a SMSF differ from other super funds?

SMSF members do not need the benefit of the consumer protection type rules applying to larger super funds with hundreds or even thousands of members, and no involvement by the members in the operations of the fund. They do not need the benefit of these rules because they are both members and trustees, and therefore are actively involved in the SMSF’s operation and able to access information about it at will.

Examples of this include:

  1. the equal representation rules between employers and employees do not apply;
  2. the rules for member inquiries and complaint procedures do not apply;
  3. there is no need to appoint a custodian or a manager to SMSF;
  4. a wider class of persons may audit the SMSF. This is because the formal qualifications for an auditor are less rigorous;
  5. the information to be provided to members is less extensive. There is no need to provide members with details regarding income and expense allocations and the general requirements to provide formal information are more relaxed, since the members have access to this information on a daily basis; and
  6. the trustees have nine months, rather than six months, from the end of the financial year to arrange for the audit to be completed and for the annual return to be prepared and lodged with the Regulator.

This means the costs of running SMSFs are lower than otherwise would be the case.

Setting up a SMSF

Who can set up a SMSF?

There is no restriction on who can establish SMSFs. They are set up by people of all ages from all walks of life. Normally people with higher incomes or who have significant wealth set up SMSFs. Older people predominate, since they are able to pay larger contributions and are more aware of their ultimate retirement. Younger people using SMSF’s to set themselves up for later life are becoming increasingly common.

How much do you need to set up a SMSF?

There is no minimum amount required to set up an SMSF. However, a common sense approach is required. The cost to set up and run an SMSF can be more expensive compared to setting up a client in an industry fund. When a client has a substantial initial balance, say $200,000, the SMSF starts to become a more attractive and cost effective option, mainly due to a fixed administration fee.

That is not to say that an SMSF will not be appropriate to a client with less than this amount to invest. There can be good reasons for setting up an SMSF where the costs are relatively high in the first few years until the SMSF grows and its investment strategy settles down, such as:

  • The client’s desire for control over their investments;
  • Intention to have larger future contributions;
  • Intention to have a simple low cost investment strategy;
  • High level of awareness and experience of investments markets and investment risk; and
  • High level of awareness and sophistication regarding potential gearing strategies.

Do you need more for a SMSF paying a pension?

The figure is closer to $200,000 for a SMSF that is paying a pension. This is because most members would be better off taking a tax free lump-sum benefit if they have any less than this, and not bothering with super at all.

ASIC’s guidance on setting up SMSFs

ASIC is currently focusing on SMSFs with fund balances under $200,000. In summary, when recommending a SMSF with a fund balance less than $200,000, advisers should include a paragraph like this in the statement of advice (SOA):

“Your SMSF will initially have a fund balance less than $200,000.  ASIC says it is concerned that such a SMSF may not be cost effective. Our meeting considered ASIC’s concerns and, in summary, it was agreed that in your case the expected advantages including greater control outweighed any possible cost disadvantage.”

ASIC has recently announced new disclosure rules for advisers recommending SMSFs. These are information sheet INFO 205 “Advice on self-managed super funds: disclosure of risks” and information sheet INFO 206 “Advice on self-managed super funds: disclosure of costs”.

INFO 205 – Disclosure of risks

This information sheet sets out the risk advisers must bring to the client’s attention when recommending client’s to roll out of an APRA regulated fund to a SMSF. The risks include:

  • The lack of statutory compensation for SMSF’s from theft or fraud;
  • The impact on insurances;
  • Lack of access to certain complaints and dispute resolution mechanisms;
  • The appropriateness of different SMSF structures (i.e. corporate trustee or individual trustees) for tax and succession planning;
  • Trustee obligations as well as the time and skill required to operate the SMSF;
  • Obligation to develop investment strategy to meet the members retirement needs;
  • Need to consider an exit strategy; and
  • Any exit fees, loss of rights or benefits, tax consequences and any other significant consequence of switching from their existing super fund.

INFO 206 – Disclosure of costs

This information sheet focusses on the costs associated with setting up, operating and winding up an SMSF.

In summary, when you recommend a SMSF to a client you should be emphasising control over investments, and expected lower net costs as your reasons to set up a SMSF. Both these advantages should feature in your SOA. You should also habitually consider leaving a certain balance, say $10,000 to $20,000, in the old fund to keep the old fund’s risk insurance alive, and take particular care to otherwise keep risk insurances in place unless the client has specifically and clearly agreed to not do so.

Documentation requirements

The SIS Act requires SMSFs to:

  1. keep minutes of all trustee meetings, including meetings of the directors of a trustee company. This minute must be kept for at least ten years from the date of the meeting, but it is a good idea to keep them for longer;
  2. keep complete accounting records. These records may be kept electronically provided they can be easily converted to paper. The accounting records must be kept for at least five years after the end of the relevant financial year;
  3. keep a copy of the deed and amending deeds and similar documents; and
  4. prepare annual accounts showing the financial position at the end of the year and the operating performance during the year.

Generally, these are minimum requirements. A wise trustee keeps more detailed records and retains them longer. But this is good management rather than a legal requirement.

The ATO have provided a short video discussing the commencement of an SMSF:

Why self-managed super fund?

Control

The main benefit of a SMSF over another super product is control over all aspects of the fund. Clients will have 100% control of where their money is invested at any time. A key feature of a SMSF is the ability to make direct investments. Direct Australian shares are a particularly good option as they will provide tax effective dividend income to the SMSF.

Clients are also able to invest in direct property, either using the available cash in their fund or through limited recourse borrowing arrangements. For example, with a geared residential property that is rented out, the rental income would cover the outgoings and the interest, with a bit of help from the contributions. With a view of an investment timeframe of 20 years, the drive of this strategy is the expected capital gain. This should not be realised until the SMSF is in pension mode (i.e. after age 60) where the bulk of the return will be capital gains tax free. More information on limited recourse borrowing arrangements is provided later on in this chapter.

Other investment options include international shares, managed funds, listed unit trusts and investment companies, artwork, and other “exotic” investments. The control clients have over their SMSF means that they can also act quickly to change their investment strategy, if their appetite to risk changes due to a change in their personal circumstances.

Increased information

A SMSF means you don’t have to wait for months after 30 June each year to find out how your investment is performing (or even what it is invested in). The information is always readily available. Most trustees can access information on virtually a daily basis.

The rapid growth in Internet trading is increasing the amount of information. Most e-traders provide free portfolio tracking software, which means clients get immediate reports on the state of their portfolios at any time. Cheap software packages like Banklink make it even simpler for SMSF trustees to run their own investment portfolios with minimum effort and maximum fun. The more expensive options like Class Super provide fast, cloud-based daily investment reporting in addition to efficient SMSF administration tools.

Synergy with other investment and business strategies

SMSFs can create synergies with the member’s other investment and business activities. The SMSF’s investment strategy should be prepared as part of an overall investment strategy reflecting the member’s attitudes and overall financial profile. The member’s will and estate planning should be considered as part of this strategy.

It can make sense for a SMSF to minimise property investments if the member’s family trust has invested heavily in property. Overall, the investment portfolio is balanced, even if the SMSF invests solely in shares. It’s hard to see how a managed fund with thousands of members of all ages, from all walks of life and with vastly different financial profiles can be as efficient as a SMSF.

Tax free death benefits

In most cases eligible termination payments paid direct to a deceased member’s dependants are tax-free in the dependant’s hands. This applies to all super funds, not just SMSFs. But as SMSFs are usually controlled by the deceased member’s nearest relatives there is more tax planning potential and certainly more control.

Asset protection

SMSF assets are generally protected from bankruptcy. This means a trustee in bankruptcy cannot access the benefits and the benefits are held for the member. Benefits paid out during a bankruptcy, say, on the member reaching a specified age, or before bankruptcy may not be protected.

Capital gains tax efficiencies

Most people know most super income is taxed at 15% and capital gains are taxed at no more than 10%, provided the asset has been held for more than 12 months. This gives SMSFs a significant advantage over other directly-controlled entities when it comes to deciding which entity should hold an asset that is expected to increase in value.

Fewer are aware that SMSF income is taxed at nil % if it used to pay a pension, and that capital gains only face tax in the year the gain is realised, not in the year the gain accrues. SMSFs allow members to eliminate CGT by controlling the timing of asset disposals. This means the realization of gains (and, in many cases, other income) can be deferred to a year when the SMSF pays nil tax, i.e. when the members are being paid pensions from the SMSF. With planning, most capital gains can be derived tax-free using this method.

And pensions can start at age 55 without the member having to stop work. This significantly increases the after tax rate of capital gain, significantly increasing the return on the investment, just by deferring the disposal of the investment.

Retirement planning for children

SMSFs can be used to obtain retirement benefits for spouses, children and even grandchildren. SMSFs are a sophisticated method of cross-generational wealth transmission.

Ethical investments

SMSFs can choose to only hold investments they believe are ethical. Trustees can structure the SMSFs’ investment strategy so that no unconscionable investments are held, or so that socially advanced investments are emphasised.

It’s a pleasure: SMSFs as an enjoyable way to spend your time

Many, if not most, people who run SMSFs do so because they enjoy it. They like the control and they are genuinely interested in investing. They enjoy learning about investment opportunities.

SMSFs do not have to take up a great deal of time. Some people get by with just a few hours a year. They only buy quality blue chip shares or some other conservative investment, such as an index fund, and never sell. This strategy has worked well in recent years and has the added benefit of lower administration costs since there are fewer transactions to record and monitor. This strategy is common with younger people with smaller funds and/or larger work and family commitments.

Other people enjoy spending a few hours a week or in some cases even a few hours a day attending to their SMSF investments. They believe they can add to its performance by paying closer attention and investing. Older people who are retired from full time practice are more inclined to do this. With the low cost of e-trading, and the huge amount of information available on the Internet, we are seeing a new class of investor who works his or her SMSF hard to make extra profits.

Whether one method is better than the other is not clear. And it really depends on the ultimate choice of investments. But for many clients spending a few hours on their investments beats playing bowls. As Barbara Smith and Austin Donnelly say in “Do It Yourself  Superannuation” under the heading “Psychological Benefits”:

“Other benefits enjoyed by some trustee members are the interest and satisfaction from buying shares or property and watching market developments closely, particularly in relation to the share market. This process is an absorbing interest for some people.”

Running a SMSF is a valid and interesting occupation: ten years ago many managed funds did not have as much in them as some SMSFs do today. Their size and cash flow means the trustees enjoy the time spent on SMSF activities.

Tax deductible life insurance premiums

Life insurance premiums paid through a SMSF can be tax deductible. In some cases this can halve the cost of the cover and is the cheapest way to arrange life insurance. Often the tax benefit connected to deductible premiums more than covers the cost of running the SMSF.

Any insurance benefits paid will be included in the SMSF’s assessable income. Whether there is a tax charge or not will depend on the fund’s tax profile: the worst case is a tax charge of 15%, and the best case is a tax charge of 0%, which will apply if the SMSF is paying an allocated pension at the time of the member’s death.

Roll-over of taxable capital gains

Small businesses, including businesses run through companies and trusts, can roll over taxable capital gains on the sale of their businesses into their SMSF. This special rule acknowledges that businesses are often the main retirement asset for many people. Conditions apply and expert advice should always be obtained.

Reversibility

If for any reason a member decides a SMSF is no longer appropriate, it’s an easy thing to reverse the decision. This can be done by the member paying himself or herself an ETP, paying tax, and then reinvesting in a non-super environment or by rolling over to a managed fund. Unlike managed funds, this reversal is simple and cheap to complete, and nothing has been wasted on entry fees and exit fees. 

Fee-for-service for your clients

SMSFs are perfectly positioned for an ongoing 30-year integration service strategies. Clients love the idea of being in control of their own money and are well disposed to SMSFs. The SMSF boom should not be a surprise, and it’s not something that’s going to stop any time soon. Expect SMSF numbers and FUM to increase significantly.

SMSFs are terrific for fee-for-service financial planners because they require ongoing financial planning services. Think about it. You (the adviser) initially advise on the set up, and the interplay between the SMSF strategy and the client’s wider financial planning strategy: think 30 days. But then you have to advise on the ongoing situation: think 30 years.

The 30-year plan has to be monitored and this includes:

  • estate planning, particularly for older clients;
  • risk insurances, and the advantages and complications created by SMSFs owning insurances;
  • the ongoing annual SMSF compliance function (yes, you should provide this, as the CRM, and subcontract it out to a low cost provider)
  • regular meetings to review the underlying investments, (which should be direct investments, i.e. bank deposits and similar, shares and properties, because this is what your SMSF clients will want) and recalibration as needed.

Never make cost an obstacle to keeping in touch with your client. Dover encourages regular adviser SMSF meetings. The meeting should focus on the immediate issue of what the SMSF is invested in, and whether this needs to change, and also discuss the client’s wider affairs and concerns. It’s likely your client will ask you do something else at the meeting, and, being happy with your services, they will recommend you to friends and family.

As per October 2015, most advisers charge around $3,000 a year (plus consulting fees, insurance commissions and other fees) to a client being provided with the full suite of SMSF services. This creates a guaranteed profit of around $1,900 for acting basically as a SMSF CRM. 100 SMSFs at $1,900 a year is $190,000 a year of extra cash flow – and perhaps $500,000 of extra CGT free goodwill – just for adding in the SMSF administration function. That’s how you create a great fee-for-service practice.

What happens if a SMSF breaches the law?

A SMSF must be a complying super fund to get the benefit of the tax concessions extended to super funds. If a SMSF seriously breaches the super law it may become a non-complying fund and may lose the benefit of these tax concessions. It may also become liable for certain penalties, as may its advisers, particularly its auditors.

It is virtually unheard of for a SMSF to deliberately become non-complying. It just does not happen except in the most extreme cases, and this is a place few people choose to go to and one we definitely recommend you stay away from. Examples might include things like buying holiday homes in a SMSF – and then using them. More common areas might be where a payment is misdirected or some other form of clerical error.

The ATO is, sensibly, mostly forgiving when inadvertent errors are made leading to non-compliance. It rarely plays a hard hand provided the error is corrected and does not reoccur. The best option for a trustee where an error has been made is to fully disclose the error to the ATO (see below for further comment here). 

Complying super fund

In order to be classified as a complying super fund the SMSF:

  1. must be a resident regulated super fund at all times during the income year (ss 10(1) and 19 of the SIS Act); and
  2. has not contravened any of the provisions in the SIS Act, or if it has the SMSF nevertheless passes the compliance test.

Compliance test

If the SMSF has contravened one of the provisions in the SIS Act, the ATO will need to consider all the relevant circumstances in deciding whether the SMSF should nevertheless be a complying super fund. Factors the ATO will consider include:

  • the taxation consequences if the SMSF is found to be non-complying;
  • the seriousness of the contraventions; and
  • all other relevant circumstances.

If the SMSF fails this test, section 40 of the SIS Act provides the ATO the power to give the SMSF a written notice that the fund is non-complying.  The ATO will generally issue a show-cause letter outlining their reasons why the SMSF should be found to be non-complying which provides the trustees an opportunity to respond or rectify the breaches.

SMSF compliance

The ATO does not issue annual notices that SMSFs are complying funds. Rather it issues an initial notice when the SMSF is first formed. Thereafter it only issues a notice if requested to do so by the SMSF, provided the ATO has not issued a notice under section 40 that the SMSF is no longer a complying fund and it is a non-complying fund. Therefore, once a SMSF is formed and has obtained an initial notice that it is a complying fund it continues to be a complying fund unless it receives a notice from the ATO saying it is a non-complying fund.

This means SMSF compliance is a self-assessment system. The SMSF’s auditor plays a critical role. The auditor must certify that the SMSF has complied with the super law and this certificate is included in the annual return lodged by the SMSF with the ATO. If this certificate is not provided the ATO will issue a notice under section 40 that the SMSF is not a complying super fund.

The audit can be broken into two parts. The first part is a financial audit and this relates to the correctness of the financial statements and related documents. The second part is a compliance audit and this relates to the SMSF’s compliance with the SIS Act, and particularly whether the fund has not breached the various laws applying to SMSFs, for example, has not acquired an inappropriate investment, has not paid out member benefits in circumstances that breach the SIS Act.

Must the auditor report breaches of the super law?

This is dealt with in section 129 of the SIS Act.

If an auditor believes that the SIS Act has been breached the auditor must inform the trustee in writing of the breach. The auditor does not have to do this if the auditor honestly believes the trustee is already aware of the breach, but a wise auditor will do so anyway.

The auditor must then report the breach to the Regulator if:

  1. the trustee does not comply with the auditor’s request for a report regarding the proposed or actual action to be taken in respect of the breach; or
  2. the auditor is not satisfied with that action.

What happens if a SMSF does breach the super law?

From time to time SMSFs will breach the super law. Usually these breaches are not deliberate and in effect excused by the ATO, provided they are disclosed and are rectified as soon as possible. We have not seen the ATO not use its discretion favourably.

In practice, it is important for the SMSF to be able to show that the breach was inadvertent, not deliberate, and was rectified as soon as practicable once the SMSF became aware of the breach. For example, way  back in the year ended 30 June 2000 a client SMSF with more than $1,000,000 lent the members’ daughter $20,000 on commercial terms to help buy a car. The SMSF believed this investment was valid, because the loan was less than 5% of the SMSF’s assets and therefore did not breach the sole purpose test. The SMSF did not realise that the investment would breach the rule against loans and other financial assistance to members. Immediately on being informed of the breach the SMSF arranged for the loan to be repaid. The auditors did not certify that the SMSF had complied with the law and specifically brought the breach to the ATO’s attention.

The ATO exercised its discretion in favour of the SMSF. It was satisfied that the breach was not deliberate and that the SMSF had done all it could to rectify the breach once it was discovered.

We expect that the situation would be different if the ATO had discovered the breach or if rectification had not been made.

What if the ATO does not exercise its discretion favourably?

We have never seen the ATO do this, but it were to not exercise its discretion in favour of the SMSF and refused to deem the SMSF to be a non-complying fund, the SMSF may seek a review of the ATO’s decision by the ATO. If the ATO still does not exercise its discretion in favour of the SMSF the SMSF may apply to the Administrative Appeals Tribunal (or equivalent) for a review of the ATO’s decision under the administrative law.

The request to the ATO to review its decision is made under section 344 of the SIS Act. The request must be in writing, must set out the reasons for making the request and usually must be made within 21 days of the ATO’s original decision. If this decision is unfavourable to the SMSF any application to the AAT for a review of the ATO’s decision must be made within 28 days of the decision.

Specific legal advice should be sought in writing regarding these options if the ATO treats a SMSF as not being a complying SMSF.

Consequences of a SMSF becoming non-complying

The ATO have released a short video explaining the process they apply when a breach occurs. 

If a SMSF ceases to be a complying fund it loses the tax concessions extended to complying funds and become liable to a tax charge equal to the highest marginal tax rate of the value of its assets, less un-deducted contributions. If a SMSF with $1,000,000 of assets on 1 July 2015 becomes a non-complying fund it will face a tax charge of $490,000 (49%).

The logic behind the tax charge being the value of the SMSF’s assets less un-deducted contributions is that this effectively reverses the tax concessions previously applied to the contributions received by the SMSF. In most cases it will go further than this, since the contributions are taxed at 15% and are possibly subject to the 15% super surcharge. There is no adjustment for this, plus the underlying assets have probably increased in value, and this increase is subject to tax at 49% even though it may not have been realized. This makes the penalties very onerous indeed.
 
This is a serious penalty, and although it is rare, it explains Dover’s conservative stance on so many issues: it’s just not worth taking risks with SMSFs and their complying fund status.

When it comes to SMSFs, choose any flavour as long as it is vanilla. 

Consequences for advisers

Advisers involved in setting up arrangements that contravene the super law may also be liable to penalties under the SIS Act. In fact the Regulator is more interested in pursuing advisers who set the arrangements up rather than the SMSFs who participate in them. This is commonsense: the adviser is presumed to have known better. 

Common problem areas

A SMSF may breach the super law in any number of ways. In a paper on SMSFs delivered to the Taxation Institute of Australia, Chris Kestidis of Hall and Wilcox, Lawyers, identified the following problem areas:

  1. special income, a situation where the SMSF derives income from related parties, such as a company or a unit trust, on a non-arm’s length basis;
  2. in-house asset rules, particularly those for investments in geared unit trusts; and
  3. sole purpose test, particularly where assets have a second purpose of being available for use by members and family and friends.

The ATO also publishes the top compliance mistakes made by SMSF trustees every year. The latest report from 2014 highlights the top 10 contraventions:

Types of contraventions reported to the ATO (up to 30 June 2014)
Contravention types Number (%) Value (%)
Loan to member/financial assistance 21.5% 15.0%
In-house assets 19.0% 28.8%
Administrative-type contraventions 10.8% 1.6%
Separation of assets 12.7% 25.4%
Operating standard-type contraventions 8.0% 6.1%
Borrowings 7.8% 7.4%
Sole purpose 8.0% 4.9%
Investment at arms length 7.7% 7.5%
Other 3.1% 1.0%
Acquisition of assets from related parties 1.4% 2.4%
Total 100% 100%

Of the top 10 the contraventions that account for almost 70% of the value of assets involved are:

  • in house assets;
  • separation of assets; and
  • loans to members and financial assistance.

We recommend SMSF trustees – and their advisers – steer clear of each of these areas and do not take risks by investing in anything other than traditional investments. In fact our attitude to these areas is hardening year by year: trustees should not do anything which may breach the laws in any of these areas, no matter how attractive the opposite technical arguments may be. It is just not worth taking a risk in any of these areas.

The Dover Group