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Self Managed Super Fund (SMSF) Article
SMSFs and Unit Trusts

By Tony Negline.

This article may be out of date.

3rd May 2005

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Australian financial services regulators have a favourite expression, “If it sounds too good to be true it often is.”  This warning is issued to remind investors to be careful before committing to anything far too outlandish.

Unfortunately some people never learn.  The desire to make great riches without effort, patience or perseverance and the losses that arise from such behaviour always seems to be around.

When it comes to superannuation which is a long term investment that has attractive tax concessions, there are plenty of ways to destroy a person's retirement nest egg.  With Self Managed Super Funds a larger array of problems can arise because the responsibilities of running a fund properly rest with the trustees who have to be the members.

The Australian Taxation Office has repeatedly told us that if a trustee breaks the rules then they must face the unpalatable consequences which can include taxing the fund's assets (excluding the fund's undeducted contributions) at 48.5% of the assets of the fund.

Recently an old strategy has resurfaced and before acting upon it a trustee should seek some very robust advice.  The strategy is presented as a way of building up an investor's superannuation assets via personal borrowings.

How does it work?  An investor borrows money and places the money in a private unit trust.  The investors SMSF also invests in the same unit trust.  With the total investments, the unit trust purchases an investment property.

The investor's borrowings are used to earn income – which would be paid via distributions from the unit trust – and therefore the interest costs and other expenses associated with the property would probably be tax deductible.

Over the following years the investor directs all their compulsory and voluntary employer superannuation contributions into their SMSF.  The SMSF trustee invests these new contributions by buying more units in the unit trust.

The investor would then repay their debt by redeeming their unit holding in the trust (the unit trust has the funds to pay out these redemptions because it has the additional investments made by the SMSF).  Over time the super fund will become the only unit holder in the trust and if the property was sold then the gain would be taxed at the concessional tax rates that apply to super funds.

It is no exaggeration to say that this strategy is very complicated and it would be very easy to make a mistake at some stage through a lack of vigilance by anyone involved in administering the strategy.

From a superannuation legislation point of view there are at least six issues that have to be addressed before a trustee should implement the strategy.

The first point to note is that a super fund cannot invest in anything unless its investment strategy allows that investment.  Further the fund's trust deed must also allow the investment.

Thirdly a specific super law does not allow a super fund to loan money or provide any financial assistance to its members or the member's relatives.  In August 2001, the tax office said that a SMSF trustee cannot allow any property it holds directly or indirectly to be used as a security for a borrowing by a member or their relatives.

As a result the property which is purchased by the unit trust cannot be used by the SMSF member as security for the borrowing they enter into in order to invest in the unit trust.  Also the SMSF cannot allow the member's units in the trust to be used as security for the borrowing.  The member would have to use some other asset as security for the borrowing.  Additionally an agreement would have to be in place between the SMSF and the other unit trust investor stating that the investor will only deal with their unitholding in such a way that would not cause the SMSF to lose its access to tax concessions or cause the trustee to breach any super laws.

Fourthly some SMSF trustees might be tempted to use this strategy to transfer a property they already personally own into a unit trust and have their SMSF purchase units in the trust.  Such a strategy might be seen as a handy way of extracting cash from the SMSF.  This can only happen with business real property.  That is, it is always used wholly and exclusively in the running of at least one business.

Furthermore parties deemed to be related to the SMSF (defined as SMSF members, their relatives or entities controlled by the members or their relatives) would not be allowed to rent the property unless it was business real property.  The only exception to this rule would be the situation where the SMSF's unit trust holding represents less than 5% of the market value of the SMSF's total assets.  If the business real property is owned by a trust or company then that trust or company must not have any borrowings and must only be leasing business real property to SMSF related parties

Finally we come to the sole purpose test.  This states that a super fund must only be run for the purposes allowed by the super laws.  The main purpose of running a super fund must be to provide retirement benefits for the fund's members.  Would this arrangement be deemed to be an elaborate arrangement to channel superannuation contributions into private hands?

Sadly some people might want to enter into this strategy to brag about it to their mates.  It would be ironic if someone entered into this strategy and then got its implementation wrong and were penalised as a result.

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