First published in the Financial Review on 12 September 2019.
This immediately raises concerns as to whether the ATO is overstepping its role as regulator. As the ATO does not have a prudential supervisory role, these letters should not be seen as an attempt by the regulator to limit the ultimate control of investment afforded to SMSFs.
However, freedom of investment choice must be balanced with the investment rules set out in superannuation law as well as the responsibilities of trustees to ensure they invest prudently. An important component of these rules is the need to formulate and implement an investment strategy.
An investment strategy should be considered the SMSF’s blueprint when dealing with the fund’s assets to ensure the SMSF’s investment objectives and members’ goals are met. It provides the parameters to ensure trustees invest their money in accordance with that strategy. This is where the ATO has a primary function to ensure that trustees act in accordance with these obligations.
It is also important to note that the ATO letters are not aimed at all SMSFs. They are part of a specific ATO campaign targeting SMSFs with a limited recourse borrowing arrangement where the trustees have used borrowed money to buy, in most cases, a single asset, primarily real property, which also represents more than 90 per cent of the fund’s assets.
The focus on these funds is not surprising given the report handed down by the Council of Financial Regulators this year that focused on SMSFs with LRBAs. Although the report dismissed any systemic risk either to the SMSF sector or the broader property market, concerns were expressed over the “prevalence of property as the main asset purchased under an LRBA, most commonly by low-balance SMSFs (under $500,000) who have little investment diversification and high loan to value ratios (LVRs), making these funds particularly susceptible to shifts in the property market”.
It’s not uncommon for SMSFs with lower member balances to find diversification a challenge, as there is limited money to invest. Nonetheless, trustees are still required to demonstrate that they adequately understand and mitigate the associated investment risks.
In the current unpredictable property market, it is timely to remind trustees of the asset concentration risk and liquidity risk associated with investing heavily in a lumpy asset such as real property
Trustees need to demonstrate that they understand that investment risk increases where the SMSF has an LRBA. Trustees will also need to show that they understand that the risk is heightened where the real property LRBA is secured with a personal guarantee that, in turn, may have allowed the SMSF to undertake larger borrowings with higher LVRs. Trustees will need to show they have considered the ability to service the loan based on the financial circumstances of the SMSF instead of looking primarily to members’ personal assets.
Adding further concern around highly leveraged and low diversified SMSFs is the withdrawal of the big banks from lending to SMSFs. This could trigger a rise in related party loans with greater reliance on the ATO’s safe harbour guidance for these types of loans to ensure that the LRBAs are consistent with arm’s-length dealings.
Interestingly, in 2019-20, the ATO guidance for safe harbour acceptable interest rates charged under an LRBA to acquire real property increased to 5.94 per cent, despite lower official market interest rates. This increase will affect existing variable loan arrangements as well as new or refinanced LRBAs. An area that has the potential for significant risk is where trustees have historically enjoyed a nil interest rate related party LRBA under the protection afforded by a private binding ruling from the ATO. What is perhaps not fully understood is that these PBRs do not apply indefinitely and may have lapsed. Trustees in these circumstances need to review their PBR as a matter of priority.
The ATO is also concerned that findings from its 2017 LRBA survey confirmed that in more than 90 per cent of instances the decision to borrow was supported by financial advice. This is particularly important when considered in the context of the recent royal commission report and the Australian Securities and Investments Commission’s reports 575 and 576, which found shortcomings in some areas of advice provided to SMSFs.
Where trustees have in place an adequate investment strategy that deals with these risks and can provide the necessary evidence to support their investment decisions, no further action is expected. Where the fund has not complied with its investment strategy requirements under superannuation law, trustees may be liable to administrative penalties being imposed by the ATO.
The ATO is also writing to the auditors of these SMSFs to alert them to the same concerns. Given recent court decisions placing greater responsibility on SMSF auditors to scrutinise more closely the investments of SMSFs as part of the audit process, these SMSFs can no doubt expect a closer review of the terms and conditions of any LRBA as part of their next audit.
Opinion piece written by
John Maroney, CEO,