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Self Managed Super Fund (SMSF) Article
Derivatives and SMSFs
By Tony Negline.
This article may be out of date.
25th April 2007
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
The super laws allow super funds to invest in derivatives. A super fund might use derivatives for a variety of purposes. For example derivatives can improve portfolio returns – via more income – or limit potential losses if a trustee is concerned about the value of an 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. One of the most well known examples is collapse of Baring Brothers caused by Nick Leeson twelve years ago.
Despite the apparent risks, an increasing number of super funds are using these products. Any super fund that uses derivatives must ensure that their trust deed and the fund’s investment strategy allow a trustee to use this type of product.
In some cases the use of derivatives will require that a charge, such as a mortgage, lien or some other encumbrance, is placed over a fund’s assets. If this occurs then the trustee can only purchase these from a recognised trading exchange such as the ASX. In this situation the trustee must also develop a Derivative Risk Statement (DRS). Before July 2004 these were called Risk Management Statements. 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 Derivative Risk Statement requirement? This obligation is an ‘operating standard’ whch 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 should see a fund’s DRS and how it has been implemented.
Most industry experts believe that Instalment Warrants have a derivative embedded in that product type. 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.
In November '06 the Howard Government revealed that the super regulators had decided that Instalment Warrants breached the rules prohibiting a super fund from borrowing. In response to this revised view the government announced that it would amend the law so that super funds could continue to use these products. This legislation is still being developed.
Another type of product that many super funds are taking a close look at are Contracts for Difference. These contracts are purchased ‘over the counter’; that is directly from a product provider and not via a recognised exchange. Some CFD providers require clients deposit assets as security against any obligations that might arise.
CFD product providers say that CFDs operate in a similar vein to other derivative type products and if a Guaranteed Stop Loss facility is used they can function like an Instalment Warrant. CFDs claim their products cost a lot less than other similar products. Can a super fund use these products?
In March '07 the ATO issued two Interpretative Decisions in relation to the use of CFDs by Self Managed Super Funds. The two Interpretative Decisions show how a CFD can and cannot be used by SMSFs. To safely navigate around the super laws, SMSF trustees need to make sure that no fund assets are deposited as security. If money is deposited then it must become the property of the CFD provider and the super can have no beneficial interest in the account. The wording of the CFD contract is therefore critical.
What are the income tax implications for a super fund using CFDs? Tax Ruling 2005/15 deals with this issue. It states that all gains made under CFDs are tax-free and losses cannot offset income from other sources unless the CFDs are being used either in the carrying on of a business or commercial transaction for the purpose of making a profit. Some claim that using CFD is like gambling. The ATO doesn’t seem to think too much of this argument.On previous occasions the ATO have said that they believe it unlikely a SMSF will ever be carrying on a business. However it is highly likely that a super fund would be using CFDs to make a profit. This means that if a super fund pays tax then it probably needs to pay tax on any profits made from using CFDs.
This email is general in nature only and does not constitute or convey specific or professional advice. Legislation changes may occur quickly. Formal advice should be sought before acting in any of the areas discussed. Be aware that the information in these articles may become innaccurate with time. Responsibility is disclaimed for any inaccuracies, errors or omissions. Particular investments are neither invited nor recommended and hence this publication is not "financial product advice" as defined in Section 766B of the above legislation. All expressions of opinion by contributors are published on the basis that they are not to be regarded as expressing the official opinion of any other person or entity unless expressly stated. No responsibility for the accuracy of the opinions or information contained in the contributor's articles is accepted by any other person or entity. Copyright: This publication is copyright. If you wish to reproduce this article you require a license, which can be purchased here, to do so.