SMSF Investment Restrictions: What You Can and Cannot Invest In

Self-Managed Super Funds (SMSFs) operate within a specific regulatory framework that defines what these funds can and cannot invest in.

While SMSFs offer more investment flexibility compared to retail or industry super funds, there are strict rules governed by the Superannuation Industry (Supervision) Act 1993 (SIS Act) and associated regulations. These rules are designed to ensure that SMSF investments are made for the sole purpose of providing retirement benefits to members.

This article outlines the various restrictions and requirements that apply to SMSF investments, including permitted investment types, prohibited activities, and compliance obligations.

SMSFs must operate within specific investment guidelines set by regulatory authorities

Permitted SMSF Investments

SMSFs can generally invest in a wide range of assets, provided these investments comply with relevant superannuation laws. Common permitted investments include:

Financial Assets

1. Cash and term deposits
2. Listed shares (domestic and international)
3. Government and corporate bonds
4. Managed funds and ETFs
5. Listed investment companies
6. Listed property trusts

Non-Financial Assets

1. Direct property (residential or commercial)
2. Business real property
3. Collectibles and personal use assets (subject to strict conditions)
4. Private company shares
5. Unit trusts
6. Physical commodities like gold

All investments must be:

1. Made in accordance with the fund's investment strategy
2. Acquired and maintained on an arm's length basis
3. For the sole purpose of providing retirement benefits to members
4. In compliance with in-house asset rules and related party transaction restrictions
5. Properly documented and recorded

Prohibited SMSF Investments

The SIS Act and Regulations explicitly prohibit or restrict certain types of investments and transactions:

Prohibited Activities and Investments

1. Acquiring assets from related parties (with limited exceptions)
2. Lending money to, or providing financial assistance to, fund members or their relatives
3. Borrowing money (except in limited circumstances under Limited Recourse Borrowing Arrangements)
4. Using fund assets as security for loans
5. Operating a business directly within the SMSF structure

Collectibles and Personal Use Assets

SMSFs can invest in collectibles and personal use assets (such as artwork, jewelry, antiques, coins, stamps, etc.), but these investments are subject to strict storage, insurance, and valuation requirements:

1. The asset cannot be leased to or used by a related party
2. The asset cannot be stored in a private residence of a related party
3. The decision about storage must be documented and kept for 10 years
4. The asset must be insured in the fund's name within 7 days of acquisition
5. The asset must be valued by a qualified independent valuer

Documentation and compliance are essential aspects of SMSF investment management

Arm's Length Requirements

All SMSF investments must be conducted on an "arm's length" basis, meaning that the terms of the transaction should reflect what would be expected in a transaction between unrelated parties dealing with each other at market value.

The arm's length rule applies to:

1. Acquisition and disposal of fund assets
2. Ongoing income from investments (e.g., rent, interest, dividends)
3. Expenses associated with fund assets

Example: Non-Arm's Length Income (NALI)

If an SMSF receives income at a rate higher than what would be expected in an arm's length dealing (e.g., excessive interest on a loan to a related party), that income may be classified as Non-Arm's Length Income (NALI). NALI is taxed at the highest marginal tax rate (currently 45%) rather than the concessional superannuation tax rate of 15%.

The ATO scrutinizes transactions involving related parties particularly closely to ensure they are conducted on arm's length terms and properly documented.

Related Party Transaction Rules

A "related party" in SMSF context includes:

1. Members of the fund
2. Standard employer-sponsors of the fund
3. Associates of members or standard employer-sponsors

"Associates" is broadly defined to include:

1. Relatives of fund members
2. Business partners of fund members
3. Companies or trusts controlled by fund members or their associates
4. Other entities with a sufficient connection to fund members

As a general rule, SMSFs cannot acquire assets from related parties. However, there are important exceptions:

Permitted Related Party Acquisitions

1. Listed securities acquired at market value
2. Business real property acquired at market value
3. In-house assets (subject to the 5% limit)
4. Units in widely held trusts
5. Assets acquired under a merger between super funds

"Business real property refers to real property used wholly and exclusively in one or more businesses. This important exception allows SMSFs to acquire business premises from related parties, provided the acquisition is at market value."

In-house Asset Limits

An "in-house asset" is:

1. A loan to a related party
2. An investment in a related party
3. An asset of the fund subject to a lease or lease arrangement with a related party

The total market value of in-house assets cannot exceed 5% of the total market value of all assets in the fund. This limit is tested at the end of each financial year and whenever an in-house asset is acquired.

Example: Compliant Fund

Total fund assets: $2,000,000

In-house assets: $80,000

In-house asset ratio: 4%

Result: Compliant (under 5% limit)

Example: Non-compliant Fund

Total fund assets: $1,000,000

In-house assets: $65,000

In-house asset ratio: 6.5%

Result: Non-compliant (exceeds 5% limit)

If the in-house asset ratio exceeds 5% at the end of a financial year, the trustees must prepare a written plan to reduce the ratio to 5% or less within the next financial year.

Exceptions to In-house Asset Rules

Certain investments are exempt from being treated as in-house assets:

1. Business real property leased to a related party
2. Investments in widely held entities
3. Certain non-geared unit trusts and companies that meet specific conditions

Investment Strategy Documentation

Under superannuation law, SMSF trustees are required to formulate, regularly review, and implement an investment strategy that considers:

1. The risk and likely return from investments
2. Diversification of investments
3. The liquidity of investments
4. The fund's ability to pay benefits and other costs
5. The insurance needs of members

The investment strategy must be:

1. In writing
2. Tailored to the circumstances of the fund
3. Reviewed regularly (at least annually)
4. Implemented for all investment decisions

Content of an Investment Strategy

While there is no prescribed format, an SMSF investment strategy typically includes information about:

1. Investment objectives (e.g., target returns, risk profile)
2. Asset allocation ranges (e.g., 20-40% in Australian shares)
3. Diversification approach
4. Liquidity requirements
5. Insurance considerations for members

A documented investment strategy is a key requirement for all SMSFs

Compliance and Penalties

The Australian Taxation Office (ATO) regulates SMSFs and can impose various penalties for non-compliance with investment restrictions:

Regulatory Penalties

1. Administrative penalties (up to 60 penalty units, currently $13,320 per trustee)
2. Education directions (requiring trustees to complete specified education courses)
3. Rectification directions (requiring trustees to address specific contraventions)
4. Disqualification of trustees
5. Civil and criminal penalties for serious breaches

Tax Consequences

1. Non-complying fund status (resulting in fund assets being taxed at 45% instead of 15%)
2. Additional tax on non-arm's length income (taxed at 45%)
3. Additional tax on income from collectibles and personal use assets that don't comply with the relevant rules

The ATO conducts regular compliance activities, including audits of SMSFs, to ensure they are complying with all relevant investment restrictions and requirements.

Conclusion

SMSF investment restrictions form an important part of the regulatory framework governing self-managed superannuation funds in Australia. These rules aim to ensure that fund assets are invested for the sole purpose of providing retirement benefits to members.

While SMSFs offer considerable investment flexibility, trustees must operate within these regulatory boundaries, including:

1. Investing only in permitted asset classes
2. Conducting all transactions on an arm's length basis
3. Complying with related party transaction rules
4. Keeping in-house assets below the 5% threshold
5. Formulating and following a documented investment strategy

Given the complexity of these restrictions and the potential penalties for non-compliance, SMSF trustees are encouraged to consult with qualified professionals, such as accountants, financial advisors, and legal experts specializing in SMSF matters, to ensure their fund remains compliant with all relevant regulations.