Many self-managed superannuation funds (SMSFs) hold unlisted assets, particularly unlisted trusts and companies which may include any loans the SMSF has made to them.
These assets are likely to invite more scrutiny from auditors and the regulator, and don’t be surprised if your client’s SMSF is required to provide further information to them.
Recent court decisions have held auditors liable for not investigating the recoverability of investments and determining the appropriate market value. Unlisted investments are now considered high-risk from an audit point of view and the Australian Taxation Office (ATO) is expecting an increase in breaches being reported. So you and your client need to be prepared.
If you’re an SMSF trustee or director of a corporate trustee, don’t think you’re off the hook either as you have a legal obligation to provide information requested, otherwise you could face penalties. Sometimes however, information gathering can be difficult. For example, you may be invested in a trust/company whose underlying investments are not valued in accordance with superannuation law. This scenario would likely trigger an audit qualification and an Audit Contravention Report (ACR) being sent to the ATO.
What’s the issue?
Each year SMSF’s are required to be audited by a registered SMSF auditor. As part of the audit, fund accounts must be prepared using the market value of assets which are published by the ATO.
Each fund investment needs to be risk-assessed on the available evidence and whether it is appropriate and reliable. This may include obtaining independent verification in many situations.
The level of evidence required to substantiate the investment may depend on the proportion of the fund allocated to the investment/loan. For example, a greater level of confidence may be required to confirm whether a loan of $500,000 is recoverable compared to a similar loan with an outstanding balance of $20,000.
The trustee of the SMSF is responsible for making sure fund assets are valued correctly as the fund’s auditor or the ATO will be able see whether the recorded value provides reasonable evidence.
A GUIDE FOR VALUING UNLISTED ASSETS
If your client’s SMSF has investments in unlisted companies or trusts, here is a guide to help if the market value of assets is not readily available, which is often the case.
Unlisted trusts and companies
In assessing the valuation of these assets, the types of supporting evidence your fund’s auditor or the regulator will look for include:
- Audited financial statements of the unlisted trust or company;
- Financial statements including evidence that underlying assets are valued at market value;
- Independent valuations of the underlying assets of the trust or company;
- A share/unit price based on recent sales or purchases between unrelated parties; and
- Written verification from a director or trustee of the trust or company who is not a related party of the SMSF.
On the flipside, further information could be requested where:
The trust or company provided unaudited financial statements with no evidence of the underlying assets being at market value;
The fund trustees have provided their assessment of the underlying asset of the unlisted investment; and
Written verification has been provided from the trustee or director of the trust or company who is a related party of the fund.
Preet and Olivia have an SMSF with a balance of $300,000. They have invested $240,000 in the ‘Hope Street investment trust’, which was established two years ago and has
18 different unit holders. The trust acquired a vacant block of land and after obtaining council approval, organised construction of an apartment building which is expected to be complete in six to eight months.
The trust has provided financial statements which show the land valued at the original purchase price two years ago.
The trustee and other interested parties will need to assess if the SMSF financials show the units at market value. There is no record of recent sales of the units available and there is no evidence as to what the building could be sold for if it was placed on the market. In addition, it cannot be determined if the unit trust has enough cash to complete construction of the building.
Based on the circumstances, the trustee may not be able to confirm the market value of the units with adequate certainty. This may result in the auditor issuing a qualified opinion for the market value of the units.
Two years later the building is completed, and an independent valuation is obtained confirming the apartment block is worth $16 million. The financials of the unit trust show that the only other asset besides the building is $2 million in cash.
The trustees revalue the units from the original purchase price. They calculate the market value by dividing the total assets of the unit trust by the total number of units issued by the trust. They have a copy of the financials of unit trust and valuation. This would normally be enough to verify the market value of the units.
Frank works at a renewable energy start-up and uses his SMSF to buy $50,000 worth of shares as part of an employee share plan. He makes the purchase in April.
The company issued a prospectus as part of the share plan which was available to all employees. As the shares were purchased by the SMSF at market value in April, which is adequate evidence to support the 30 June market value for that financial year.
One year later, the value of the shares within Frank’s SMSF remain at $50,000. Although Frank obtained a copy of the company’s financial statements, it is a small business and does not require its financials to be independently audited. No recent share sales or purchases have occurred.
Even though the accounts were not qualified by the auditor it may occur in the next year as there is insufficient information to confirm the market value of the shares.
Loans to an unrelated trust or company
If your client’s SMSF makes a loan to an unrelated trust or company, or even to an unrelated individual, there are things you or your client should know. The loan agreement needs to specify the terms and conditions of the loan including how the interest rate is determined, whether the loan is secured or unsecured and the term of the loan. This is of interest in relation to the purpose of the loan and the business of the borrower.
Recoverability of the loan will have an influence of its market value. Evidence could include:
- Whether repayments have been made as required by the loan agreement;
- Details on the financial position of the borrower confirming the ability to repay the loan (e.g. net asset position, sources of cash); and
- Details and value of security held as collateral for the loan (if applicable).
On the other hand, unsatisfactory evidence, likely to invite greater scrutiny, would include statements made by the fund trustees or the borrower that provides an assessment of the recoverability of the loan. The evidence needs to go further than that.
A copy of the loan agreement and evidence that interest has been paid on the loan merely establishes that the loan exists. But it doesn’t provide enough evidence of the loan’s value, whether it is recoverable and the borrower’s financial position concerning future repayments.
Liz’s SMSF has made a $300,000 loan to Anthony, a friend and property developer. Two-year loan term with an interest rate of 8% p.a and monthly payments which Anthony always meets. The loan agreement lists Anthony’s home, worth $1.5 million, as security. The SMSF financials show the loan at $300,000 on the balance sheet. A title search for Anthony’s property confirms that Liz’s SMSF has a charge registered against the property.
In this scenario it would normally be accepted that the loan is valued correctly. If Anthony was to default on the loan, Liz would be able to take possession of his home and recoup her loan investment. If on the other hand, Liz’s SMSF hadn’t registered a charge over the property, the auditor would probably qualify the audit unless Anthony could demonstrate his assets less any liabilities exceed the loan value.
WHAT DOES A QUALIFIED AUDIT REPORT MEAN?
Just because an SMSF has received a qualified report from the auditor is not necessarily a reason to panic. The financial and compliance sections of the audit report may be qualified if the auditor has not been able to obtain enough and appropriate evidence concerning the investment. As trustee of your SMSF, you will be contacted by the fund auditor and the ATO notified if a reportable breach has occurred.
A qualified audit report does not necessarily mean your client’s SMSF is non-complying and that they are up for penalties. The auditor will notify the ATO if a reportable breach has occurred, may have occurred or where it cannot be identified with enough certainty that the fund has met an audit standard.
Both the auditor and ATO will consider the circumstances case-by-case. The ATO may ask your client to supply further information where the investment is material and there is an indication that the value used may not be an appropriate reflection of the market value.
FUTURE PROOFING YOUR UNLISTED ASSETS
It’s always sensible to ensure that the advice you provide on any investment undertaken by your client’s SMSF is correctly documented, especially if the trust or company is unlisted or there is a loan to an unrelated party. As you can see, the client will need to provide adequate evidence to establish the existence of the investment and whether it is recoverable. If this information is not available, the SMSF may end up with a qualified opinion and an ACR sent to the ATO.
Graeme Colley is executive manager, SMSF technical and private wealth at SuperConcepts.