Date posted: 10/09/2019

The ATO SMSF investment strategy letter – Not the ogre it appears to be

Here we provide the CA ANZ perspective.

In brief

  • ATO letter sent to small number of SMSFs who have LRBA and bulky asset
  • Many media claims appear to use to be over the top
  • We explain how CAs can help their clients

About 17,000 SMSF trustees will receive a letter from Tax Office about their fund's investment strategy.

The letter has attracted adverse comments in the media and its timely for Chartered Accountants ANZ to provide our perspective to help CAs and their clients.

Understanding the background

Before we discuss the ATO's letter there are number of points that need to be made:

  1. Under the super laws the ATO is a compliance regulator – that is, its job is to ensure that SMSFs comply with the super laws.  (On the other hand APRA is a prudential and compliance regulator – its job is to ensure third party members' and beneficiaries' interests are protected and that fund's comply with the super and other laws.)  Obviously the ATO ensure compliance with various tax laws by all super funds.

  2. Each year trustees declare on their SMSF annual return that "I have received a copy of the audit report (If required) and am aware of any matters raised therein.  The information on this annual return, including any attached schedules and additional documentation is true and correct."

  3. All SMSF trustees should have executed the ATO trustee declaration which includes the following words:

    "I also understand that by law I must prepare, implement and regularly review an investment strategy having regard to all the circumstances of the fund, which include, but are not limited to:
    • "the risks associated with the fund's investments
    • "the likely return from investments, taking into account the fund's objectives and expected cash flow requirements
    • "investment diversity and the fund's exposure to risk due to inadequate diversification
    • "the liquidity of the fund's investments having regard to the fund's expected cash flow requirements in discharging its existing and prospective liabilities (including benefit payments)
    • "whether the trustees of the fund should hold insurance cover for one or more members of the fund."

  4. The 2018/19 SMSF approved audit form states the following – "My reasonable assurance engagement has been conducted in accordance with applicable Standards on Assurance Engagements issued by the Auditing and Assurance Standards Board, to provide reasonable assurance that the trustees of the fund have complied, in all material respects, with the relevant requirements of the following provisions (to the extent applicable) of the SISA and the SISR … Regulations … 4.09

  5. Regulation 4.09 of the SIS Regs is an "operating standard" – that is, it is a provision that must be complied - and states the following:

  6. "The trustee of the entity must formulate, review regularly and give effect to an investment strategy that has regard to the whole of the circumstances of the entity including, but not limited to, the following:

    "(a) the risk involved in making, holding and realising, and the likely return from, the entity's investments, having regard to its objectives and expected cash flow requirements;
    "(b) the composition of the entity's investments as a whole, including the extent to which they are diverse or involve exposure of the entity to risks from inadequate diversification;
    "(c) the liquidity of the entity's investments, having regard to its expected cashflow requirements;
    "(d) the ability of the entity to discharge its existing and prospective liabilities;
    "(e) whether the trustees of the fund should hold a contract of insurance that provides insurance cover for one or more members of the fund."

  7. A key feature of the NSW Supreme Court case Ryan Wealth Holdings Pty Ltd v Baumgartner was the fund's written investment strategy and the court deciding that the trustee had not invested the fund's money in accordance with that strategy

  8. In February 2019, the Council of Financial Regulators (RBA, ASIC, APRA and Treasury) published a report to government about leverage and risk in the superannuation system.  That report states, "less diversified SMSFs with LRBAs are … exposed to asset concentration risk, which in the event of a fall in the asset's price, could lead to a significant loss in value of the SMSF. Further, this high degree of asset concentration could exacerbate risks to SMSF members if personal guarantees are involved, leading to a loss of personal wealth beyond superannuation".

The ATO letter

The letter has the following opening paragraphs:

"Our records indicate that your self-managed super fund (SMSF) investment strategy may hold 90% or more of its funds in one asset, or a single asset class.

"This means that your fund may be at risk of not meeting the diversification requirement as outlined in the operating standard of the Superannuation Industry (Supervision) Regulations 1994.

"As a trustee you are ultimately responsible for ensuring your investment strategy meets the requirements under the law. You could also be liable for an administrative penalty of $4,200 if your investment strategy fails to meet these requirements."

It then concludes with the following:

"We will also be writing directly to the auditor of your fund to notify them of our concerns. You should be aware that if your auditor identifies that you have failed to rectify any non-compliance with the requirements listed above; this could result in the imposition of the above mentioned penalties."

Who will receive this letter?

As noted above this letter will be sent to about 17,000 SMSFs that have at 90% of their total assets, as reported to the ATO in a single asset or asset class and the fund also has a Limited Recourse Borrowing Arrangement.  That is, it is being sent to about 3% of all SMSFs.

Reactions to date

CA ANZ has seen the following claims in the media:

  • The ATO are alleging that having one asset class is a bad thing or at lest implied it is wrong
  • This represents a "full scale assault" on both SMSF trustees and auditors
  • SMSF clients who are elderly will be unduly worried
  • This is yet another example of the ATO seeking to place a level of distrust against tax agents
  • The ATO are asking auditors to warrant investment strategies – a task they are unlikely to be qualified or permitted to do
  • The legislation doesn't actually require a written investment strategy, it just requires the trustees to 'formulate, review regularly and give effect'
  • Robert Gottliebsen in The Australian (9 September 2019) makes the following claims:
    • "The Tax Office has taken tentative steps into financial planning
    • "It's threatening tone indicates that this just the start of a thrust akin to the withdrawal of ABN numbers from small enterprises
    • "The vast majority of self-managed superannuation funds have 90 per cent plus of their funds in one asset or one asset class invested in one or two properties. Most made the decision confident they were complying with the superannuation rules that did not nominate a fixed percentage.
      "The investment strategies usually fall into two baskets: First, those properties that are occupied by the beneficiaries' business. They include warehouses, factories shops etc. Second, residential dwellings where there was often high borrowing. The categories raise very different issues…
      "The ATO seems to be concerned about liquidity. Big funds where members can withdraw their money at short notice need liquidity. But when the beneficiary is the same person or persons as the trustee it's not an issue. The beneficiaries know they can't access the cash until the property is sold and they arrange their affairs accordingly."
    • "The ATO people have few if any financial planning qualifications. Perhaps that's why they mentioned the figure of 90 per cent in the letter. I can't find a figure of 90 per cent in any of the legislative requirements. It looks like the ATO made it up. And because they are above the law I guess they can."

    Source: (only accessible behind a paywall)

CA ANZ's reaction to the ATO letter

Given our ongoing relationship with the ATO we appreciated seeing, under embargo, drafts of this communication.  We provided extensive comment at the communication. 

Together with other industry associations we encouraged the Tax Office to remove from the communication the reference to the potential financial penalties.

The ATO however was concerned that some trustees might ignore the communication (or later complain) if the letter did not sound an adequate warning about the legislative requirements and the penalties that could apply.

CA ANZ considers that some of the above commentary to be incorrect or, at best, misleading.

For example:

  • It would seem difficult for an SMSF auditor to plead ignorance with the investment strategy requirement – after all they sign the ATO approved SMSF audit report which says they performed a reasonable assurance engagement to confirm compliance with Reg 4.09
  • Auditors are not asked to state that the investment strategy is correct for a fund – they are asked to verify that the strategy provided to them meets the requirements of Reg 4.09 (that is, it clearly takes into account all the points required including diversification) and that the strategy has clearly been implemented by the trustee when operating their fund.  They are not asked to provide retail financial product advice (as defined in the Corporations Act) to SMSF trustees
  • Trustees can't argue they don't know about this investment strategy requirement – they've signed the trustee declaration and each year sign their annual return stating that everything in the return is true and correct including the report prepared by their fund’s auditor
  • In relation to the superannuation laws, the ATO is a compliance regulator not a prudential regulator – they can only assess investment strategies against the requirements of Reg 4.09
  • Whilst strictly true that investment strategies do not need to be in writing it would be difficult for an auditor to validate an investment strategy complies with Reg 4.09 that is not in writing

We disagree with the following media comments (refer above):

  • "The Tax Office has taken tentative steps into financial planning"
  • "The vast majority of self-managed superannuation funds have 90 per cent plus of their funds in one asset or one asset class invested in one or two properties"
  • "The ATO people have few if any financial planning qualifications. Perhaps that's why they mentioned the figure of 90 per cent in the letter. I can't find a figure of 90 per cent in any of the legislative requirements. It looks like the ATO made it up. And because they are above the law I guess they can.

Our recommendation to CAs

To date, in many cases, the investment strategy document piece has been a box ticking exercise with the use of pro-forma documents that contain 5 or 6 investment classes and allowable ranges between 0% and 100%.

The Baumgartner case, and to a lesser extent the McGoldrick NSW Supreme Court cases, burst this bubble.  In our view pro-forma documents are unlikely to suffice.

  • For tax agents and SMSF administrators who are not licensed financial advisers:

    You can help your SMSF trustees understand their investment strategy obligations.  Some key questions are:
    • what are you trying to achieve in your fund for your member(s)?  That is, what is your fund's objective?  For some, the answer might be "a decent retirement"; for others it might be "returns of CPI plus 3%" (which is like the government's Future Fund objective)
    • what assets will you use to meet these objectives and what evidence do you have that these particular investments will help your fund to meet this objective; why not other types of investments that you have excluded?
    • how will the fund's cashflow requirements (ideally this should be for the short, medium and long term) be met from those investments?
    • do any of your members need insurance – if so, what sort of insurance?
    • what do you mean by diversification – by asset class, within asset classes or some other rule – and how has this requirement been met in your fund?

    The above is not an exhaustive list.  Having settled on answers to these questions trustees then need to show how each particular investment or insurance product helps them achieve the fund's objective and strategy.

    For obvious reasons you cannot recommend specific financial products and investments.

    And this process needs to be completed annually either via confirmation that the existing objectives and strategy and their implementation are still valid or with appropriate adjustments.

  • For tax agents and SMSF administrators who are licensed financial advisers

    Like unlicensed Chartered Accountants you can help your clients understand their legal obligations as per the above points.

    Clearly your ability to assist your clients select particular financial products and investments will depend on your AFSL authorisations.

  • For SMSF auditors

    For many years your job has been to check that the fund has an investment strategy which takes into the five limbs of Reg 4.09 and that the strategy has been implemented – that is, investments or insurance selected by the trustees line up.  For example, if a fund’s primary purpose is to pay pensions to its members yet has insufficient liquidity to make those payments – and cannot dispose of any assets – then there is a problem with the implementation with that strategy.

    SMSF auditors are not asked to judge if the strategy is suitable for the particular fund or if particular investments are suitable overall.  Their primary focus is compliance with Reg 4.09 – that is, tell me what you're trying to achieve and then show me how you have gone about putting those thoughts into concrete action.