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Self Managed Super Fund (SMSF) Article
Super Funds and Contracts for Difference
By Tony Negline.
This article may be out of date.
17th November 2004
The super laws allow super funds to invest in derivatives that are offered under rules established by most futures and stock exchanges throughout the world.
Derivatives are financial assets or liabilities whose values are determined by other assets, liabilities or indices. There are many different types of derivatives. For example, forwards, futures, options, warrants, swaps, share ratios, etc
A super fund might use derivatives for a variety of purposes. For example derivatives can spectacularly improve portfolio returns or limit potential losses if a trustee is concerned about the value of the asset falling.
These powerful products will only work successfully if an investor knows what they are doing. Some very large companies have gone broke when a few rogue employees have misused derivatives or derivative type products.
Despite the evident risks, an increasing number of super funds are using these types of products. Any super fund that uses derivatives must make sure that their trust deed allows a trustee to use this type of product. Under the super laws a super fund that uses derivatives must also have a Risk Management Statement (RMS). These statements must reflect three key issues:
- policies for the use of derivatives that include an analysis of the risks associated with the use of derivatives within a super fund’s Investment Strategy
- restrictions and controls on the use of derivatives that take into consideration the expertise of staff
- compliance processes to ensure that the controls are effective (for example, reporting procedures, internal and external audits and staff management procedures)
What penalties apply for not complying with the Risk Management Statement requirement? This obligation is an ‘operating standard’. Operating standards are specific principles which super funds must meet in fund administration and operation at all times. A failure to satisfy these requirements can lead to a range of fines and penalties. A super fund’s external auditor would be expected to see a fund’s RMS and how it has been implemented. The auditor would be expected to report any breach to the regulator.
Most industry experts believe that Instalment Warrants have a derivative embedded in that product. The purpose of the derivative in the Instalment Warrant is to protect the product issuer if the IW purchaser decides not to fully pay for the underlying investments.
As IWs have derivatives, most industry experts agree that super funds that invest in IWs would need to also have a RMS.
Another type of product that many super funds are taking a close look at are Contracts for Difference.
Matthew Wilson, Managing Director of IG Markets, a provider of these new CFD products argues that CFDs operate in a similar vein to other derivative type products. Wilson argues that when an investor purchases a CFD and also elects to use a Guaranteed Stop Loss facility, they are effectively buying an Instalment Warrant.
“The Guaranteed Stop Loss means the investor can simply walk away from their CFD much like an Instalment Warrant client can,” he said.
Wilson on face value cannot see why a super fund would not be allowed to use CFDs. “Some super funds are already using our CFD products. Presumably the trustees and their advisers have satisfied themselves that CFD are OK under the super laws.”
Shawn Irvine of DBA Lawyers holds a different view. He argues that a super fund cannot use CFD because derivatives, or derivative type products can only be purchased by a super fund if the derivatives have been issued by a body specifically mentioned in the super laws. “CFDs are not issued by stock and futures exchanges,” Irvine said.
Irvine is also of the view that CFDs breach the super borrowing restrictions. “All CFDs including those with Guaranteed Stop Losses have potential future margin calls built into them,” he concludes.
With the differing opinions out there what should a prudent trustee do? DIY Super understands that the ATO is currently reviewing CFDs from a Self Managed Super Fund perspective and is expected to release a document at some future date.
What would be the income tax implications for a super fund using CFDs? Two months ago the ATO issued a draft tax ruling on CFDs. It states that all gains made under CFDs are tax-free unless the CFDs are being used in the carrying on of a business. At the same time losses earned from CFD cannot offset income from other sources. On previous occasions the ATO have said that they believe it unlikely a SMSF will ever be carrying on a business.
It should be noted however that thus far we only have a draft tax ruling. This means that it only represents the preliminary views of the ATO and as such can’t be used as a justification for completing their tax return in a certain way. As with all draft rulings no time-frame is detailed when it will be finalised. Some rulings have been finalised very quickly. Others have been outstanding for many years.
Some industry practitioners, believe that the basis of draft tax ruling is faulty and have suggested this to the ATO.
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