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The ATO’s latest focus on diversification is a “wake-up call” for funds to consider all relevant investment risks, particularly those that have utilised limited recourse borrowing arrangements, says the Tax Institute.
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ATO diversification letters a ‘wake-up call’
13 September 2019
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Close to 18,000 funds have now received letters from the Tax Office because records show these SMSFs hold 90 per cent or more of funds in a single asset class.
The Tax Institute’s senior tax counsel, Professor Robert Deutsch, believes the ATO is not trying to dictate the type of investments made, but is instead concerned over funds that have used limited recourse borrowing arrangements (LRBAs) to make a leveraged 90 to 100 per cent investment in one property.
Indeed, the ATO’s assistant commissioner, Dana Fleming, has since revealed that 98 per cent of the funds contacted in the letter campaign had property with an LRBA as their chief asset.
“Such LRBA arrangements should never have been allowed under any circumstances as the strategy inevitably puts superannuation assets at undesirable levels of risk from market downturns,” Professor Deutsch said.
“A 90 to 100 per cent investment of a fund’s available resources in leveraged arrangements of this kind further exacerbates the situation and such an investment is just looking for trouble and will find it, at the very least, in the form of enhanced ATO scrutiny.
“It seems that a large proportion of the target letters concern these types of situations which only adds to the problems already experienced by such funds where property prices have in many cases tanked and left the heavily undiversified fund with a huge commercial problem and now a related tax/regulatory one.”
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Professor Deutsch believes the letters highlight the need for the investment strategy to go beyond considering diversification issues, but also issues of risk, investment returns, liquidity and cash-flow needs.
“This really is a wake-up call for trustees, and particularly for auditors, that the ATO wants to see greater scrutiny to ensure that all these issues have been properly considered. Mere motherhood statements without evidence to back them up may no longer cut the mustard,” he said.
“Where LRBA arrangements are being contemplated, in my view, the investment strategy should strictly limit the fund’s exposure to such leveraged investments to a specific ceiling.
“The ceiling should be set in consultation with a qualified financial planner who could make a proper, realistic assessment of the downside risk, but it could be something like this — at the outset, the investment in the property subject to the LRBA arrangement will be no more than 40 per cent of the total investable pool of resources available. This would give some reasonable room to manoeuvre in the event of a significant property downturn.”
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