Self-managed Funds Flying In Face Of The Sole Purpose Test

Sydney Morning Herald

Saturday March 8, 2008

Annette Sampson

The great rush to pump up to $1 million into super before July 1 last year has been a windfall for promoters of self-managed super funds. New registrations of self-managed funds peaked at 11,444 in June - or almost 3000 new funds a week.

Self-managed funds have enjoyed the highest growth rate in the super industry in the past 10 years and control more than $300 billion in assets. There are now more than 372,000 self-managed funds looking after the retirement savings of more than 718,000 investors - who, by the way, have a healthy $362,000 average account balance, by far the highest in the super industry.

The self-managed fund story can be summed up in one word: control. Self-managed funds are the natural vehicle for people who want to control their own retirement savings, rather than passively investing through a public super fund. For those investors who sold rental properties to contribute their $1 million in the latter part of 2006/7, a DIY fund often seemed at natural extension of their hands-on investment strategy.

But unfortunately many investors are still under the illusion that they can run their self-managed fund with the same abandon as they managed their non-super investments. And in some cases, the level of control actually exercised is laughable.

The Tax Office, which regulates self-managed super funds, has been banging the drum on fund compliance for several years. The assistant deputy commissioner Ian Read was at it again at a recent Institute of Chartered Accountants in Australia conference.

Read revealed the Tax Office had started contacting newly registered funds last July to find out why they had set up their funds, whether they understood their obligations, and to nip any illegal tricks in the bud. It has already contacted more than 1000 new fund trustees and plans to contact 3000 all up - either by phone or letter.

Not surprisingly, the most common reason for starting a fund was control. Two in five listed it as their main motivation. But their knowledge did not always stack up.

The single most important law for any super fund is the sole purpose test. There's a legal definition, but the gist of it is simple. The sole purpose of any super fund must be to provide retirement benefits for members. If you are thinking of using your fund to improve your current lifestyle, to help your business out in a cashflow crisis, or to set up some investments for the kids, chances are you have already stepped over the line.

If you understand this principle, you are likely to avoid 95 per cent of the potential pitfalls in running your own fund. But Read says the Tax Office found almost a third a new trustees could not explain what this test was. Furthermore, the Tax Office found a quarter of new trustees were unaware of restrictions on assets than can be acquired from related parties, and two-thirds could not specify the limit on in-house investments in a self-managed fund.

This is important because these are the areas where the Tax Office finds funds are still contravening the law. And after treading softly in the earlier years of its regulatory role, the Tax Office has shown it is prepared to throw its weight around where trustees have not made a genuine effort to follow the rules.

Read cited one recent example of a fund that had lent 98 per cent of its assets (which were all cash) to a member. There were no loan agreements, no repayments had been made, and the money had been used by the member for a business venture. To make things worse, the member was in financial strife and could not repay the loan.

The Tax Office deemed the "loans" an early access arrangement and amended the member's tax return to include these withdrawals. It also imposed a penalty.

The trustees volunteered to wind up the fund, but the Tax Office has also moved to disqualify them as trustees and is considering a civil prosecution.

Read said the Tax Office is reviewing 550 funds where loans represent 80 per cent or more of assets. It has already found cases with clear contraventions of the rules. In some cases, the member or trustee has even used the funds to buy a family home.

Read said not all of these cases represent flagrant rule breaking. The majority of these loans have been advanced to unrelated third parties with an established loan term and written agreement. But many of these loans are unsecured and are not decreasing in size - raising the risk that they will not be repaid.

Read said that in some cases tax agents had introduced the borrower to the super fund and fostered the relationship. He questions whether the returns are high enough to justify the risks involved. In other cases, he says, interest on the loans is capitalised for tax reasons, which also increases the risk the loan may not be repaid.

He said the lack of awareness by trustees raises the risk of fraud, with many trustees taking a blase approach to their retirement savings. One trustee lent $200,000 to someone they met at a social function with an extremely basic loan agreement and no loan security. Their total fund had only $220,000 in assets. The borrower absconded with $180,000 of that money and is now bankrupt and under investigation for fraud.

But it has been a painful lesson for the fund's members.

With the Government having approved a means by which super funds can borrow to invest through non-recourse loan arrangements, there is a high risk more funds are going to come into the Tax Office's sights. The temptation to break the rules by doing things like buying investment properties from members or "investing" in a holiday home will be too much for some - particularly if they have not taken the time to understand the rules and unscrupulous promoters are egging them on.

But with penalties like losing your fund's tax concessions, administrative penalties, and civil prosecutions in the Tax Office's armoury, trustees need to know that control does not mean you can do what you like.

© 2008 Sydney Morning Herald

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