13 Sep 2019 13 September 2019
SMSFs – ATO notices regarding possible breaches
Some 18,000 SMSFs are currently being contacted by the ATO regarding concerns the ATO has that the relevant funds are holding 90% or more of their money in a single asset class. The concern relates to the apparent failure to properly take into account the issue of diversifying the fund’s investments and the consequent outcome that the fund’s entire assets can be put at risk by one investment class going pear-shaped.
The ATO is asking that trustees properly and fully review the SMSF’s investment strategy and clearly document the reasons that underpin the SMSF’s investment decisions. The ATO is also requiring the revised documentation be provided to the auditor at the next audit to enable the auditor to see that there is a bona fide investment strategy in place and that the actions of the trustees are consistent with that strategy.
To be clear, the investment strategy is an important document that is not limited to canvassing just issues of diversification, although that appears to be the main thrust of the recent ATO letters. It must also address broader issues of risk, investment returns, liquidity and cash flow needs (eg cash flow needs to satisfy rolling pension obligations).
This really is a wake-up call for trustees and particularly for auditors that the ATO wants to see greater scrutiny to ensure that all these issues have been properly considered. Mere motherhood statements without evidence to back them up (eg the trustees have fully considered all relevant investment risks!) may no longer cut the mustard.
What does all this mean in practice?
Interestingly, it seems to me that the ATO has no general mandate to tell SMSFs or their trustees how to invest the fund’s assets. All they can do is ensure that everyone complies with the law including the sole purpose test which must have some relevance in this context. More specifically in this context, regulation 4.09 of the SIS Regulations requires all trustees to consider diversification. Beyond that, I am unconvinced as to the ATO’s power, in strict legal terms, to regulate what type of investments SMSF trustees can make.
Having said that, taking the ATO’s power at its very broadest, I don’t think all this means that a fund can’t have all its investments in one asset class. I know of many small to medium sized funds where investments are held 100% in cash or 100% in blue chip publicly listed shares. Provided the investment strategy properly addresses all the relevant issues – lack of asset class diversification, risk, returns, liquidity and cash flows – and the investments are consistent with that explanation, the ATO should not have a problem.
More problematic, and I think this is the real target of the ATO letters, are funds which have utilised the otherwise permissible limited recourse borrowing arrangements (LRBAs) for SMSFs to make a leveraged 90 to 100% investment in one property.
From a policy perspective, my views have been well-documented previously – such LRBA arrangements should never have been allowed under any circumstances as the strategy inevitably puts superannuation assets at undesirable levels of risk from market downturns. A 90 to 100% investment of a fund’s available resources in leveraged arrangements of this kind further exacerbates the situation and such an investment is just looking for trouble and will find it, at the very least, in the form of enhanced ATO scrutiny.
It seems that a large proportion of the target letters concern these types of situations which only adds to the problems already experienced by such funds where property prices have in many cases tanked and left the heavily undiversified fund with a huge commercial problem and now a related tax/regulatory one.
Where LRBA arrangements are being contemplated, in my view, the investment strategy should strictly limit the funds exposure to such leveraged investments to a specific ceiling. The ceiling should be set in consultation with a qualified financial planner who could make a proper, realistic assessment of the downside risk but it could be something like this – at the outset, the investment in the property subject to the LRBA arrangement will be no more than 40% of the total investable pool of resources available. This would give some reasonable room to manoeuvre in the event of a significant property downturn.
As always, I welcome your thoughts and comments via the TaxVine feedback inbox.
Bob Deutsch, CTA