SMSFs & private company shares

My client wants their SMSF to buy shares in a private company. What do they need to consider to make sure their fund complies with the super & tax law?

Whenever an SMSF wishes to buy shares in a private company, there are several super law and tax issues to be considered including:

1. Why do they want to invest in the company?

As for any fund investment, the purchase of shares in a private company must align with the sole purpose test (ie providing benefits to members on their retirement or their family in the event of their death) and no other purpose. For example, the motivation for the investment shouldn’t be to help a mate get their business venture off the ground.

2. Will the purchase be in the best financial interests of the members?

Again, the motivation for the trustee must be maximising the financial returns to the members having regard to an appropriate level of risk.

3. Will the acquisition 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. 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.

4. Will the investment be an in-house asset?

If the company is a related party of the SMSF (ie it is controlled by the members and/or their relatives etc), the shares will be considered an in-house asset and subject to the 5% limit. For example, if the value of the fund’s total assets was $1m 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.

5. Will this be a new issue of shares by the company or a purchase from someone?

If 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? This is because SMSFs are generally prohibited from acquiring assets from related parties. However, acquiring shares in a private company from a related party would be allowed if the company is controlled by the members and/or relatives etc (ie the shares will be an in-house asset and must fall within the 5% 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.

6. Is the acquisition part of an employee share scheme?

Does the private company employ the fund member? If so, were they offered the opportunity to invest in the company because of their employment relationship? And were they then able to nominate their SMSF to “take up” their share entitlement?

If so, 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.

7. Will the trustee be able to determine the market value of the shares each year?

When preparing their annual financial statements, SMSF trustees are required to value the fund’s assets at market value. This is generally relatively easy for listed investments or even real property but can be difficult when the asset is an unlisted security. What if the trustee has no control over the company and no ability to force the directors to provide an up to date valuation? Unfortunately, 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.

8. Is there a risk of non-arm’s length income (NALI)?

All dividends from private companies paid to super funds are NALI and taxed at 45%, 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.

An unusual investment like this does require careful documentation when it comes to the fund’s investment strategy, particularly if it will be a large part of the portfolio. Our Super Toolkit guides you or your client through the process of creating a strategy that recognises some of the unique considerations for investments like this.