As SMSF trustees and advisers become more familiar with the flexibility of the SMSF structure, attention is being focused on just what different types of assets can be used within an SMSF. While most people are familiar with the normal asset classes and vehicles that are used, moving beyond these familiar borders can lead to unexpected consequences if not done correctly.
The Cooper review has brought some focus onto particular types of exotic assets namely, artwork, collectibles and in house assets. So what do SMSFs need to be aware of if they wish to pursue these investment options?
The major areas to examine are:
- What constitutes “exotic” assets
- The practical & legislative considerations to be addressed prior to making this type of acquisition
- Ongoing considerations such as valuation and cash flow management.
What is “exotic?”
When most trustees think of an exotic asset the first thing that usually springs to mind is artwork and collectibles but in reality this category is much more widespread. So what are the characteristics that make an asset “exotic” from a superannuation perspective?
The obvious dividing line would be between financial assets and physical assets, with physical assets including the usual suspects of artwork, collectibles, wine, bullion, motor vehicles and equipment & machinery. In reality it is possible that even some financial assets are exotic and this is due to characteristics of their structure.
If we look at the characteristics of the physical assets there are some key elements which help us determine that they are exotic. There would be no secondary market or an inefficient secondary market for the purchase or disposal of the investment. This would raise issues for both the capacity to liquidate the asset as well as valuation of the asset. Additionally, the basis for valuing these types of assets without disposal is varied. Do you follow an accounting basis, a financial management basis or some 3rd party valuation which may or may not be conflicted.
Consider that in 2009 APRA sent a letter to large superannuation funds on the matter of valuation of unlisted assets and queried whether trustees should just accept the investment manager valuations without appropriate validation of the underpinning methodologies being performed. So if this is a concern for these superannuation funds then DIY Superannuation funds will face similar issues with exotic assets.
When we examine the characteristics of exotic physical assets we can see that there are also financial assets to which they can also apply and these may need to also be considered as exotic assets. This is particularly the case where the underlying assets are unknown or the control is placed with a separate entity. This would include private equity, hedge & absolute return funds, CFDs and some closely held trusts.
The basic investment requirements
So let’s go back to the basics about what governs an SMSF investment.
Trust Deed & SIS Restrictions:
Firstly, does the SMSF Trust Deed and SIS permit the asset acquisition? The Trust Deed may actually have an explicit clause that limits the type of assets that can be held or it may refer to any asset permitted by SIS. For SIS itself we need to contemplate the acquisition of asset restrictions if the current owner is a related party as this would restrict all physical assets except for business real property.
Similarly we need to consider if the asset is usable? If it is usable then is the usage by a related party, in which case the in house asset limitation of 5% of the SMSF value will come into play.
Even the exotic financial assets could have issues with the acquisition rules or in house asset rules if there are connections between the SMSF and either the other investors or the entity responsible for the asset.
Investment Strategy
Then we need to look at the SMSF’s investment strategy, to see how this covers the new investment. This will mean it needs to consider the additional impacts that the asset could have on aspects like cash flow and asset allocation. This means that apart from the traditional asset allocation parameters that apply there may be additional limits or measures needed to deal with the quantum and the characteristics of the exotic assets.
To determine the asset allocation aspects of the investment strategy, the question about the relevant asset class of the exotic asset will need to be answered. For the non-financial assets there will be the need to create a new sub-class for assets other than real property but for exotic financial assets it will be necessary to drill down into the underlying nature to determine which asset class is appropriate. Lack of transparency may not assist in this task.
Exotic assets by their nature are generally indivisible and illiquid, as a consequence of these characteristics it is prudent that any SMSF trustee that intends to acquire such an asset consider: * the implication that its ownership will have on the SMSF’s capacity to manage its cash flow requirements and * provide timely access to liquidity to meet both its expenses and benefit liabilities as they fall due.
If the asset is being used then a written lease arrangement should be in place which outlines both the amount of payments due and the obligation of both the SMSF as owner and the user of the asset. If no income is arising from the exotic asset then there should be an indication of why and how capital appreciation is expected to arise from the asset. In this circumstance it would be expected that this is an indication that the asset is not being used and then associated costs for storage of the asset would most likely be incurred.
This would mean that these costs would need to be met from either contributions or earnings from other SMSF assets. Of course if the SMSF is in pension phase this would place added pressure on the cash requirements of the SMSF over and above the minimum pension level.
Payment of benefits
When we consider major lump sum benefit payments then additional concerns may be raised by the ownership of an exotic asset. In normal circumstances it is expected that assets will be liquidated and cash payments made to make lump sum benefits.
It is possible to make in specie benefit payments by transferring over title of an asset as an alternative where the ability to dispose of the asset may be limited but there are several considerations in this case. Even though the asset is not being sold the SMSF will be crystallising a CGT position with a potential tax liability to be paid by the SMSF and there may be state duty costs for the transfer of title of the assets due. In the case of an exotic financial asset extra paperwork will be needed to ensure that the terms and conditions of the investment permit the transfer of the asset to another party.
Supporting documentation
One of the key issues with exotic assets is having adequate evidence of both the acquisition of the asset and the ongoing entitlements and expenses relating to the asset. With most financial assets this is not a general concern as there are systematic registries of ownership, revaluation and production of documents in relation to dividends, distributions or interest. This type of evidence will need to be produced for all exotic assets, both physical and financial. When the financial assets are not widely held the provision of this information can be significantly harder to procure.
Proof of ownership is particularly difficult with physical assets other than real property as there is no central register of title. This is compounded by the concern over where these physical assets are stored. Also particular to physical assets is that they may be subject to degradation, either naturally or due to other actions. This means that for natural degradation some form of depreciation will need to done. In relation to other reductions in value this could occur due to damage or theft of the asset in which case the matter of insurance of the asset as well as security of its storage should be addressed.
Conclusion
Exotic assets are an increasing large part of the DIY Superannuation investment arsenal however it is important that just as with “vanilla” assets the same rigorous principles are adhered to about whether or not the investment is suitable for the SMSF. These investments should not be used just because they are the latest thing in the investment market.
Government responses to both the Cooper Review and the Future of Financial Advice outcomes could result in tighter restrictions on just what type of investors are permitted to use exotic assets. There is no guarantee that SMSFs will fall on the side of the line that permits their future use.