SMSFs with derivatives cautioned on compliance risks

In an online article, Mr Song explained that derivatives transactions include a broad assortment of instruments such as options, futures, warrants, swaps or contracts for difference (CFDs).

“A derivative is fundamentally a contract between parties where the value of the contract is ‘derived’ from that of the particular asset(s) the contract is linked to,” Mr Song said.

“In a typical derivatives investment, the investor enters into a contract (which gives rise to certain contractual rights and obligations between the parties) without the investor actually owning the underlying assets that the contract is linked to and derives its value from. The underlying assets can include shares, commodities, currencies and a variety of other asset types.”

As with other investment options, Mr Song reminded SMSFs that investing in derivatives must satisfy the sole purpose test.

“The fund’s trust deed should also be reviewed to check whether the proposed derivatives investments are permitted by the fund’s trust deed,” he said.

The investment strategy of the fund should also be reviewed, he said, to see if the proposed derivatives investment is within its scope.

He added: “Financial implications of investing in derivatives including the associated risks with such investment should be carefully considered and it would be advisable for trustees to seek appropriate financial advice in this regard.

“This will also help them discharge their general trustee obligations in relation to trust investments (including SMSFs), which obligations are incorporated as overarching covenants in the SIS Act.”

If the derivatives give rise to a charge over the assets of the fund, Mr Song said there is an additional requirement to have a formal derivatives risk statement in place.

“Not all derivatives require the investor to give a charge over its assets as security. If, however, an SMSF trustee is investing in a derivative which requires the trustee to give a charge over the assets of the fund, the trustee must have in place a formal derivative risk statement and comply with the terms of the statement throughout the investment period,” he explained.

A derivative risk statement, he said, should set out what policies the trustees will adopt in the use of derivatives, how the trustees will analyse and assess the risks associated with the use of derivatives, and how the use of derivatives fits in with the investment strategy of the fund.

It also needs to cover what restrictions and controls the trustee will put in place to regulate the use of derivatives, particularly taking into account the expertise available to the fund and the compliance processes to ensure the controls are effective, he added.

The ATO expects SMSF auditors to check that an appropriate statement is in place and that the relevant derivatives investments, and the charge thereby given, are consistent with the terms of the statement, he cautioned.