Lyn Formica, head of education and content at Heffron said one of the first things an SMSF should consider is the motivation for investing in a private company.
“As for any fund investment, the purchase of shares in a private company must align with the sole purpose test of providing benefits to members on their retirement or their family in the event of their death and no other purpose,” she said.
“For example, the motivation for the investment shouldn’t be to help a mate get their business venture off the ground.”
The purchase of shares in a private company has to have the best financial interests of the members at its core, she said, and must have regard to an appropriate level of risk.
Ms Formica added that the acquisition of shares must also align with the fund’s investment strategy.
“The trustee’s investment strategy should explain how they think the proposed investment will meet the fund’s investment objectives including return objectives and cash flow/liquidity requirements,” she said.
“Where the investment in the private company will be significant, the trustee should also acknowledge the risks of inadequate diversification, the flow on effect that could have on member benefits and why they consider the likely returns will outweigh those risks.”
The shares will be considered an in-house asset if the company into which the fund has bought is a related party of the SMSF is controlled by the members and/or their relatives.
In this case the shares will be considered an in-house asset and subject to the five per cent limit.
“For example, if the value of the fund’s total assets was $1 million and the company was a related party, the fund’s total investment in in-house assets would be limited to no more than $50,000,” Ms Formica said.
As SMSFs are generally prohibited from acquiring assets from related parties, Ms Formica said it is important to ensure the shares are already on issue.
“Then it will be important to identify the seller of the shares. Is it a related party of the fund?’ she said.
“Acquiring shares in a private company from a related party would be allowed if the company is controlled by the members and/or relatives, that is, that the shares will be an in-house asset and must fall within the five per cent limit.
“If the company is not controlled, for example, the fund would be a minority investor only, the fund will be prohibited from acquiring the shares from a related party.”
There is also questions that can arise as to whether the acquisition is part of an employee share scheme.
Ms Formica said if the private company employs the fund member, and they were offered the opportunity to invest in the company because of their employment relationship and nominate their SMSF to “take up” their share entitlement it is possible the ATO would consider the arrangement to be similar to an employee share scheme.
“There are a number of issues to be considered when SMSFs invest via employee share schemes and specialist advice should be sought,” Ms Formica cautioned.
Finally, Ms Formica said valuation of the assets could prove to be problematic as valuing unlisted assets such as private company shares can be challenging.
“The availability of up-to-date information is one of the things SMSF trustees need to consider when making investment decisions. An SMSF may not be the right structure for this investment if market values won’t be readily available,” she said.
“All dividends from private companies paid to super funds are NALI and taxed at 45 per cent, unless the amount paid to the fund is consistent with an arm’s length dealing.
“There may be a risk of NALI if, for example, the SMSF pays less than market value for the shares or services are provided to the company by related parties and an arm’s length price is not paid for those services. It will be important to ask your client questions about their relationship with the company before the investment is made.
“As you can see, whilst SMSFs are generally permitted to invest in private companies, there are a number of issues to be considered before you can give your client the green light.”
Glad to see market value being raised. As a matter of practicality, this is probably one of the most important issues SMSF trustees and their advisers will face. We are all quite skilled at pointing out the potential compliance issues, but the practicalities are often ignored.
The advice should be, if you intend on investing in a private company or unit trust, ask them to confirm in writing and in advance that they will have the company or trust valued annually, and provide a set of financial statements. If they won’t agree, DONT do the investment.
If it is a company with an operating business, the valuation is likely to be more onerous and expensive, so the type of valuation needs to be agreed, not just what the directors think the value might be, as the SMSF auditor is unlikely to accept it.
Promoters of unlisted property trusts and the like don’t need to provide market values to ordinary investors. If they have SMSF investors, auditors have been so poor in pushing this issue in the past that they don’t realise it is a problem. These trust managers need to be educated; if you don’t want to provide a supported market value and financial statements annually, then don’t accept money from SMSFs, it’s that simple!
With the new ATO emphasis on SIS Reg 8.02B, many SMSF trustees are now bearing the brunt of audit qualifications and ACR’s for the first time because they can’t obtain a market value for an investment.
The advice is simple. If the fund manager won’t supply a market value, redeem it, because that’s the only option the ATO will likely give you.
Tell the company or trust manager that. The prospect of losing investors can produce surprising results!