SME guide to Cooper super review

The final report of the Cooper superannuation review, released by the Government yesterday afternoon, is likely to have some significant consequences for the most-favoured form of superannuation among SME owners – self-managed super funds.

Certainly, the review’s final report gives a big tick to self-managed super funds (SMSFs) in general, describing the $400 billion-plus sector as “largely successful and well-functioning”. And certainly the changes recommended to the Government for self-managed funds are much lighter than for the rest of the super industry.

But if the Government picks up most of Cooper’s recommendations for SMSFs – as can be expected given the sound, well-explained reasoning behind them – thousands of SMSFs run by SME owners will have to change several of their practices.

Here are our four tips for SME owners with their own funds:

1. Don’t worry if your business premises are held in your SMSF.

Fortunately, the Cooper review makes no recommendations about business real estate held in SMSFs – even if rented to the members’ own businesses. This should be seen as a key win for many SME owners.

Significantly, business real estate is expressly excluded in law from being classified as a so-called in-house asset of a SMSF, which the Cooper review wants to prohibit funds from owning.

A common strategy among SME owners is to hold their business premises in their self-managed funds with their businesses paying the funds a commercial rent. In turn, the rental income is concessionally taxed within the funds. This practice is acceptable under the Superannuation Industry (Supervision) Act.

And an added advantage is that the business premises are broadly untouchable to creditors if the fund members later fall into personal financial difficulties.

The only possible recommendation in the Cooper review that could have any future effect on business real property in a self-managed fund is that the Government should keep a close watch on gearing by SMSFs.

2. Think about how to refocus your SMSF’s investment portfolio if it holds related-party investments.

The Cooper review has strongly recommended to the Government that self-managed funds be barred from holding even a small percentage of what are known as in-house assets. This would mean, in layman’s terms, the barring of all-related party investments with the exception of business real estate.

It is a reality that many SME owners because of their typical commercial approach to their affairs are likely to have some related party assets in their self-managed funds.

In-house assets include loans, investments or leases involving related parties of the fund. The Australian Financial Planning Handbook, published by Thomson Reuters, explains that related parties include fund members and entities (including trusts) that are majority-owned or controlled by members, their partners and relatives.

Under prevailing superannuation law, a self-managed fund cannot hold more than 5% of its assets (based on value) in in-house assets. The Cooper review recommends that the SMSFs be prohibited from acquiring new in-house assets, and funds with existing in-house assets be given five years to either get rid of them or become what is known as a small APRA fund with a professional, APRA-approved trustee.

The Cooper review says one of the purposes of the in-house asset maximum is to limit the “extent to which business funding arrangements can be distorted, particularly in the small business sector, through access to relative cheap, tax-advantaged working capital from a related SMSF”.

And the report adds: “…the current exemptions still provide an avenue for potential abuse, which is inconsistent with Government policy, and whose regulatory compliance costs across the superannuation system outweigh the benefits they bring to individual funds.”

If the Government accepts this recommendation, more SMSFs will focus on more conventional assets such as listed shares and bonds.

3. Be cautious about gearing levels in your DIY fund.

The Cooper review states emphatically that “leverage should not be a core focus for SMSFs”.

The Superannuation Industry (Supervision) Act was amended in September 2007 to unequivocally allow self-managed funds to borrow to buy investments – using such means as instalment warrants – provided strict conditions are met.

While the Cooper review notes that the level of borrowing by funds under this amendment began modesty, it appears to have gathered pace. Surveys by investment researcher Super Trends records that more than 5% of SMSFs are now borrowing to invest using the likes of instalment warrants.

Many submissions to the Cooper review called for greater regulation of borrowing by SMSFs. And its report recommends that the Government review in two years time the 2007 relaxation of the borrowing rules and consumer protection measures to ensure that borrowing has not become a significant focus of SMSFs.

This recommendation has a series of potential implications for some SME owners. First, the self-managed funds of many SME owners would borrow heavily to buy their members’ business premises. Second, some of the marketing of self-managed fund gearing products would be directed at SME owners because of their general fondness for having their own funds.

A crucial factor to keep in mind is that the Cooper review’s concern about the extent of borrowing by SMSFs would largely echo a more widespread apprehension about the degree of SMSF gearing. Depending upon the circumstances, extensive borrowing by a fund can upset its asset allocation and expose the fund to the possibility of losing much of its value.

The 2007 borrowing amendment to superannuation law stipulates that a lender’s recourse in the event of a fund’s default in loan repayments (perhaps if a geared investment loses much of its value) must be limited to the asset itself – not to the other assets of a fund.

Nevertheless, a defaulting fund could lose its initial deposit on the geared investment – possibly hundreds of thousands of dollars – repayments to the date of default and any fees or interest already paid.

Given the fund gearing recommendation of the Cooper review, it is not difficult to envisage the Government tightening of the borrowing provision sometime in the future. Be prepared.

4. Think about how your fund’s diversification may have to change if it owns paintings, antiques or classic cars.

The Cooper review recommends that the Government prohibit self-managed funds from owning collectables and personal-use assets. And the review suggests that funds already with these investments be given five years to get rid of them or to convert to a small APRA fund.

We would have all heard of entrepreneurs who mark their success by acquiring their favoured collectables as “investments” for their SMSFs.

“While the panel recognises and supports the freedom of investment choice that SMSFs afford their members,” the Cooper review states, “it believes there are certain types of assets that should generally not be regarded as investments that build retirement savings…”