1.0 Audit Verification of Unlisted Equity Investments
Due to the unusual nature and specific risks of unlisted equity investments these additional audit procedures will apply:
i) Our audit will review the Fund Investment Strategy to ensure the investment is in accordance with the Strategy.
ii) Our audit will ensure the investment is recorded in the title of the Fund and any related party investments are highlighted.
iii) The market valuations shall be substantiated by reviewing the financial statements of the investee entities and other supporting documentation.
iv) Any income or capital distributions will be reviewed for potential risk of penalty tax due to Non-Arms-Length-Income. (NALI).
1.1 Superannuation law requires a trustee of the SMSF to comply with the sole purpose test when administering the SMSF.
Whether the purchase of private company shares complies with the sole purpose test depends on whether the investment is appropriate for retirement purposes having regard to the risk and rate of return on the shares. For instance, if the SMSF were to invest in shares in a highly volatile and risky private company, then there may be an issue as to whether such an investment satisfies the sole purpose test.
1.2 The Fund Investment Strategy should specifically address the investment in unlisted shares, where the amount of the investment exceeds 5% of net fund assets.
2. Is the investment a dealing with a related party?
2.1 Very broadly, a related party of a SMSF covers related parties of the SMSF’s members and entities controlled by SMSF members. SISA sec70E says any entity that the members control is a related party. Control means the members, and their associates (as defined by Part 8), control more than 50% of the Board or the voting shares.
2.2 Since the private company shares are not a listed security, the SMSF will not have been able to have acquired the shares if the vendor was a related party. The SMSF could have acquired the shares from an unrelated party.
2.3 The in-house asset rules are the other main provisions regulating a SMSF’s dealings with related parties. The in-house asset rules prevent a SMSF from having more than 5% by market value of its assets as in-house assets. Where a SMSF exceeds this 5% limit, the SMSF trustee must dispose of its in-house assets to get under the 5% limit.
2.4 Broadly, an ‘in-house asset’ is:
i) a loan to, or an investment in, a related party of the SMSF;
ii) an investment in a related trust of the SMSF; or
iii) an asset of the SMSF that is leased to a related party.
There are some exceptions to the in-house asset relating to business real property and investments in non-geared trusts and companies.
2.5 The private company share investment has in-house asset issues if the investment causes the SMSF to acquire more than 50% of the shareholding in the private company or if directors of the private company were accustomed to act in accordance with the wishes of SMSF members. This is because the proposed share investment would be an in-house asset.
2.6 The SMSF would not be affected by these related party rules where it acquired the private company shares from an unrelated party, the shares do not represent a majority interest in the private company and SMSF members do not control the board of directors of the private company
2.7 The ownership and financial statements for any unlisted investments should be reviewed for highlighting potential related party investments.
3.0 Market Valuation
3.1 As the investment entity is unlisted, obtaining a market valuation may be more difficult than with listed investments. Care should be exercised when assessing market value of unlisted investments as they are usually riskier than listed company investments, even if in the same industry.
3.2 We may accept trustee valuations, provided they are undertaken in an acceptable manner and accord with known market conditions. (See ATO guidelines for acceptable market valuations).
3.3 Any error in valuation should be dealt with in the normal manner, with particular concern being taken of the 5% in house assets rules.
3.3 The ownership and financial statements for any unlisted investments should be reviewed to support the market valuation of unlisted investments.
4.0 Will the dividend received on the shares be arm’s length dividends?
4.1 A final issue relates to whether the income derived from a SMSF investment (in this circumstance, the private company shares) is affected by the non-arm’s length provisions in tax law.
4.2 The non-arm’s length provisions are aimed at ensuring that income is not inappropriately diverted to a SMSF to take advantage of the lower 15% superannuation fund tax rate. The non-arm’s length provisions apply where a SMSF derives income from a non-arm’s length arrangement. Where the provisions apply the SMSF is taxed on the non-arm’s length income at the highest marginal rate (currently 47%).
4.3 The arm’s length provisions have a wide reach. The fact that the SMSF’s purchase of the private company shares was at arm’s length sometimes may be not enough to prevent the provisions applying. For instance, if the private company enters into a non-arm’s length dealings and distributes the profits made from those dealings to the SMSF then the arm’s length provisions may apply depending on the circumstances.
4.4 Where a SMSF makes an arm’s length investment in a private company and the private company does not engage in non-arm’s length dealings with the SMSF or its related parties, then the SMSF should generally not be affected by the non-arm’s length provisions.
4.5 Where the income or capital gain exceeds benchmark index for the investment category, and the income exceeds say, 5% of fund income, the transaction should be reviewed for potential NALI.
4.6 To decide whether the amount is consistent with an arm’s length dealing, consider any connection between the private company and the SMSF, as well as any other relevant circumstances such as:
i) the value of the shares held by the SMSF in the company
ii) the cost to the SMSF of the shares on which the dividends were paid
iii) the dividend rate on those shares
iv) whether dividends have been paid on other shares in the company (and at what rate)
v) whether the company has issued shares in lieu of dividends to the SMSF and the circumstances of the issue.
4.7 In a situation where we have concern that there may be NALI, the implication for error in the income tax expense and the provision for income tax should be assessed. Where likely to be material or significant we may seek independent taxation advise on the likelihood of the income being NALI.
4.8 Should such expert advice be obtained, and it can be obtained from any properly qualified and experienced tax practitioner. The advice must be in writing and provide a reasonably arguable position for the viewpoint the income is not NALI. We may rely on such advice for our audit opinion.
4.9 Where we can rely on independent expert advice, that is the advice provides a reasonably arguable position, as to whether an income or capital distribution from an unlisted investment, does not pose a material NALI risk to Fund, we can issue an unqualified audit opinion. Nevertheless, where the amount of the potential error is material, a matter of emphasis should be added to the audit opinion and the issue highlighted in the auditor’s letter to trustees. A matter of emphasis is NOT an audit qualification for the purposes of the responses required in the Fund Annual Return to the ATO.
4.10 Where expert advice is NOT available to give assurance that an income or capital distribution from an unlisted investment does not pose a reasonable NALI risk to the Fund, we should issue an audit opinion with a scope limitation. We should exclude the tax implications of the transaction from our audit opinion. Where the amount of the scope limitation is material to the accuracy of the accounts, the scope limitation is considered to qualify the audit opinion on the financial statements. For the purposes of the Fund Annual Return to the ATO it will be a qualified audit opinion. The scope limitation should be highlighted in the Auditor’s Letter to the Trustees as a matter for attention of the Trustees.
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