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Self Managed Super Fund (SMSF) Article
SMSFs owning shares in private companies
By Tony Negline.
This article may be out of date.
13th July 2005
A super fund can’t run a business.
But can a Self Managed Super Fund invest in a business? In most cases the answer will be yes. But before any investment is made it is important that trustees follow a proper process.
Before a super fund makes any investment, it is essential to check the fund’s trust deed to ensure that it can actually make the investment.
It is also essential to ensure that the fund’s investment strategy allows the investment to take place. Often a trustee will determine that an investment is appropriate for their fund and would like to proceed but it conflicts with the fund’s investment strategy. In this situation a trustee can either amend their investment strategy or decide not to proceed. (Surprisingly in most cases DIY Super sees the trustees decide that the investment strategy needs to be amended!)
Next a trustee always has to be vigilant about the “in-house asset rules”. These rules only allow a trustee to limit their total investment in assets which are deemed by the super laws to be in-house assets to 5% of the market value of a fund’s total assets. An in-house asset includes leases (of fund assets), loans or investments in companies or trusts that the fund trustees, members or their relatives control, or, are deemed to control. There are a range of assets that do not fall into the in-house asset category.
If the 5% maximum is breached then the trustee must take action to address the problem.
A trustee should also be careful about how it acquires any share or unit holdings. The holding cannot be bought from a fund member, their relatives or entities that these people control or are deemed to control.
The tax consequences of investing in a small business must also be considered by a trustee. Under the tax laws, any income distributions that a super fund receives from a private company or trust will be automatically taxed at 48.5% tax. This tax can be reduced to 0% if the investment is backing current pension liabilities (such as allocated pension accounts) and 15% it is backing other liabilities (such as pre-retirement benefits).
There are two issues which we need to explored further.
Firstly, what is meant by ‘private company’? In this area of the income tax laws, a private company is, in general, a company which is not listed on a stock exchange at the end of a financial year and has less than 20 shareholders who own at least 75% of the equity in the company or have a right to 75% of the voting power or dividends paid. The Australian Taxation Office calls this the “20 75% test”. The legislation gives the ATO the ability to deem a private company a public company. Interpretative Decision 2004/760 details some of the issues the ATO follows to make a positive judgement.
Secondly, the normal super fund tax rates will apply only if the Australian Taxation Office determines that the income or capital proceeds received from a private company or trust is not excessive. The issues which the ATO must take into account are found in the income tax laws. Draft Tax Ruling 2000/D11 explains the process that the ATO uses to make its decision as well as some pointers as to when an arrangement might not be acceptable.
Specifically, the ATO must consider the value of the shares in the company that a super fund has, how much the super fund paid for the shares on which a dividend is paid, the rate of dividend paid to the super fund by the company, whether the company has paid a dividend on other shares (and, if so, at what rate), if the shares were issued because the super fund reinvested a dividend then what were the circumstances that surrounded this transaction and other matters the ATO considers relevant.
The ATO notes that company dividends would be special income if the profits of that company are largely dependant upon the efforts of personnel who are members of a share owning super fund and those employees are not taking a market salary. The ATO’s concern here is obvious – salary is being diverted to dividends which are then being paid to the company.
Any distributions that a private trust makes to a SMSF can also be Special Income. In most cases discretionary trust distributions will be tax at 48.5%. Other arrangements exist for fixed trust structures.
There are two ways for a SMSF to find out the views of the ATO on their own circumstances. One way is to apply to the ATO for a Private Binding Ruling. Another way is assume the income is not special income and make your case if the ATO disagree with you during an audit. If you prefer certainty in your arrangements then you would probably prefer the first method.
It is very common for SMSF trustees to be approached to help fund a new business concept. SMSF trustees not only need to look at the commercial side of such proposals. They must also have one eye on their regulatory and tax obligations.
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