Has the ATO come knocking about your SMSF's Investment Strategy?

In August 2019, the ATO began contacting SMSF trustees and their auditors where ATO records indicated that more than 90% of an SMSF's funds were held in one asset (or a single asset class) and which also had a limited recourse borrowing arrangement in place. The ATO's focus is on reminding trustees of their obligations regarding a fund's investment strategy, including responsibilities around diversification and risk.

This article outlines the factors that SMSF trustees are required to consider when preparing the investment strategy, and the nature of the trustees' obligations in relation to diversification.

ATO letters

The ATO in its media release of 18 September 2019, has noted its concern that:

While a trustee can choose to invest 90% or more of their retirement savings in a single asset or asset class, concentration risk combined with leveraged borrowings, can expose the SMSF and its members to unnecessary risk if a significant investment fails.

Accordingly, the ATO has written letters to funds which have entered into limited recourse borrowing arrangements which also have asset concentration risk, reminding trustees to:

• review their investment strategies;
• clearly document the reasons behind the investment decisions;
• ensure that they have considered each of the Requirements set out below; and
• rectify any non-compliance with the Requirements.

The ATO has advised that it will also write to the auditors of these funds to notify the auditors of its concerns. Where trustees fail to comply with the Requirements, then the ATO could impose administrative penalties on the fund's trustee.

What your investment strategy must consider

Under superannuation law, there are standards which apply to the operation of SMSFs which concern investment strategies. The trustee must formulate, review regularly and give effect to an investment strategy which has regard to the whole of the circumstances of the fund. The circumstances to be taken into account include:

• the composition of the fund's investments as a whole, including the extent to which they are diverse or involve exposure of the fund to risk from an inadequate diversification;
• the risk involved in making, holding and realising, and the likely return from the fund's investments, having regard to its objective and expected cash flow requirements;
• the liquidity of the fund's investments, having regard to its expected cash flow requirements;
• the ability of the fund to discharge its existing and potential liabilities; and
• whether the trustees of the fund should hold insurance which provides cover for a member or members of the fund^[1].

(together, Requirements)

What if there's no or limited diversification in a fund's investments?

The lack of diversification in a fund's investments is not of itself a compliance issue. However, by investing in a single asset or asset class, the trustees must be able to show that they have met their obligations at law in making a decision about that investment.

At a minimum the trustees must:

• adopt an appropriate investment strategy;
• make investments on behalf of the fund which are in accordance with the investment strategy;
• record the reasons for making their investment choices;
• review the fund's investments against the investment strategy and record reasons as to why the trustees consider that the investments are appropriate; and
• record each of the above measures in a set of minutes - on each occasion the trustees consider and make an investment, and on each occasion that the trustees revise or review their investment strategy.

If the fund considers that an approach which involves the fund being exposed to risks from inadequate diversification is appropriate, then it is important for the fund to specify its reasoning in a set of minutes.

The trustee should prepare minutes which evidence that the fund has:

• reviewed its investment strategy; and
• turned its mind to the composition of the fund's investments as a whole, and its compliance with the law.

These minutes and the fund's investment strategy should be kept ready to provide to the fund's auditor at its next audit. Thereby, evidencing the fund's compliance with the Requirements set out above.

If a trustee is unsure about the fund's compliance with the law and the compliance of the trustee's obligations, including in relation to its investment strategy, then trustee's should seek their own legal and accounting advice.

More information from Maddocks

For more information, contact Maddocks on (03) 9258 3555 and ask to speak to a member of the Commercial team.

More Cleardocs information on related topics

You can read earlier ClearLaw articles on a range of topics

[1]Regulation 4.09 Superannuation Industry (Supervision) Regulations 1994 (Cth)