Can A SMSF Invest In A Private Company or Business?

It is possible for an SMSF to invest in a 'non-conventional' asset, such as a private company or a business. The key is to ensure that the investment is made in accordance with the trust deed and with special attention to the sole purpose test, related party and in-house investment rules.
 
 Let's start with the trust deed. A highly descriptive trust deed can certainly be a useful reference for accountants and advisers attempting to guide SMSF clients as to whether a particular investment or approach to investing is appropriate or legal. For example, our trust deed provides instant answers to most common questions asked by SMSF accountants, advisers and their clients, instead of simply referring you to the relevant section of the SIS Act.
 
Your SMSF trust deed can be kept updated for next 5 years for  $165. It can also be instantly updated to ensure investments undertaken are compliant and likely to maximize outcomes for members. 
 
Our SMSF trust deed also spells out the purpose of the investment strategy and the importance that the trustee makes investments in accordance with that stated strategy. We offer bulk discounts if you want to update all your clients SMSF trust deeds, click here to learn more.
 

Does it pass the sole purpose test (Sec 62 of SISA)?

The next critical factor to consider when determining whether an investment in a private company or business is appropriate is whether it adheres to the sole purpose test.
 
The sole purpose test is a fundamental provision of the Superannuation Industry (Supervision) Act 1993 (SIS). The test is the legislative expression of the whole objective for introducing compulsory superannuation in the first place - to grow a non-government source of income for retirees and lessen the aging population's dependence on the age pension.
 
Under the sole purpose test, the use of concessionally-taxed superannuation savings for a purpose such as:
Providing pre-retirement benefits to fund members
Providing benefits to employer-sponsors, or
Facilitating estate planning
 
is prohibited.
 
The sole purpose test provides that super funds, whether APRA-regulated or self-managed, must be maintained solely for at least one CORE PURPOSE or for at least one CORE PURPOSE and one or more ANCILLARY purposes, as outlined in SIS Section 62, Regulation 1.03, 13.18.
 
A core purpose is the provision of benefits: 
On or after a member's retirement
Upon reaching age 65 or 
Upon earlier death
 
Ancillary purposes include:
Provision of employment termination insurance
Salary continuance on a member's cessation of work due to ill health
Reversionary benefits or other benefits on or after a condition of release has been met
 
This is the area in which the SMSF trustee must ensure they don't cross the very fine line drawn between investing in a business and using their SMSF to run a business. The former is acceptable, the latter, it could be legally argued, does not align to either a core or ancillary purpose under the sole purpose test.
 
When discussing with an SMSF client whether an investment in a private company complies with the sole purpose test, a simple way to explain the concept might be to ask whether the trustee intends to make the investment so it will increase in value over time or provide the fund with ongoing income, both of which can be used to pay a benefit upon the retirement or death of a member.
 
The ATO has already made it clear that if an SMSF crosses the line into conducting a business, as opposed to investing in one, then it does not pass the sole purpose test. The trustee needs to look closely at whether the acquisition of an interest in an unlisted private company could be considered to be a 'normal' investment activity or whether it does constitute running a business.
 
Some indicators that the SMSF has crossed the line might be if the business is operated by related parties or if a fund member generates a non-super income from the business.
 
Trustees must also ensure that all investments are made on an ar

Is it an arms-length transaction?

ms-length basis. The best and simplest way to assist an SMSF trustee to determine whether an acquisition has been made at 'arms length' is to ask the question, would a reasonable person acting in their own commercial best interests have made the same investment decision?
 
SMSF trustees need to also be informed that they must be wary of making investments in unlisted private companies for the purpose of generating regular income via dividends. That's because dividends paid by related private companies are called special income to complying super funds and are deemed to be non-arm's length income, which will be taxed at 45%, not 15%. The SMSF would need to request that the Commissioner uses s 295-550 of the Income Tax Assessment Act 1997 to deem the dividend not to be non-arms-length.
 

Does it adhere to related party rules?

The SIS Act also sets out very clear rules in regard to related-party transactions that accountants and advisers need to consider when guiding SMSF clients about investing in businesses and unlisted private companies.
 
A related party includes: a fund member, an employer sponsor, or a 'Part 8 Associate' of a member of employer sponsor.
 
An 'investment in' or a "loan to" a related party is considered to be an instance when an SMSF provides money or assets to a related party for the purpose of receiving income, interest or profit. In the world of income and expenditure, the only thing that matters is how others credit their account balances with debits in your account. As the line goes, business is all about making profits.
 
A 'Part 8 Associate' can be: relatives of the member or employer sponsor; members of the same SMSF, or if the SMSF has one member with a corporate trustee, each company director.
 
Other 'Part 8 Associates' include: a trustee of a trust where the individual controls that trust, or a company sufficiently influenced by the individual, a Part 8 Associate of the individual or two or more of these entities. An individual is considered to have control of a trust if they are entitled to more than 50% of the income or capital, if they have the power to appoint or remove the trustee or if they may oblige the trustee to act according to their directions.
 
The individual would be considered to 'sufficiently influence' the company, for example, if they held a majority voting interest in that company. The SIS Act, s 70B provides a comprehensive list of 'Part 8 Associates'. However, the most important factor is that if the individual did have a controlling interest in the private company; it would then be deemed to be an in-house asset. (See ATO Ruling 2009/4, Para 157).
 

Is it an in-house asset?

If the interest in the business was classified as an 'in-house' asset, it may still be considered to be within the bounds of the SIS Act if, and only if, it is purchased at market value and if the transaction wouldn't mean the SMSF was in breach of the 5% in-house asset limit.
 
 In-house assets include: loans to a related party; an investment in a related party; an SMSF asset that's subject to a lease between the trustee and a related party.
 
A related party loan includes arrangements involving the repayment of money, but also includes the sale of goods or land on credit, installment payment arrangements, deferred repayment arrangements or a situation where there is no intent to gain interest, income or profit such as an interest-free loan.
 
The bottom line is that if an SMSF client wishes to stay on the right side of the ATO, they must make investments for the purpose of generating income and profits for the retirement benefit of the fund's members, not for the current benefit of members or related parties.
 
The other tactic that the SMSF trustee can use is to ask for a written ruling from the ATO as to the validity of the investment before making the acquisition.
 

Key discussion points:

It is possible to invest in an unlisted private company or business but careful consideration needs to be given to the impact that investment will have on the SMSF's tax and regulatory status. Accountants and advisers need to take any SMSF trustee considering such a transaction through each of the following points:
 
Make sure you use a SMSF trust deed that is descriptive and flexible or click here to learn how to update it.
Ensure the SMSF has a written, comprehensive and up-to-date investment strategy;
Ensure the SMSF trustee makes investments in line with that investment strategy;
Ensure investments are made and maintained on a commercial arms-length basis;
Don't acquire assets from related parties (with exceptions);
Don't lend to other members of the SMSF or relatives;
Ensure an investment in a private company is limited i.e. that it doesn't give the SMSF a controlling voting right;
 
If the investment does give the SMSF a controlling voting right in the company, the investment cannot be more than 5% of the total SMSF assets;
 
Monitor any in-house asset carefully on an ongoing basis. The trustee would need to ensure, for example, that the value of shares purchased in a private company did not increase in value over time to the point where they exceeded the 5% in-house assets threshold.