In specie transfers in the frame

PORTFOLIO POINT: Farewell in specie transfers to super? The government has just labelled some SMSF trustees 'liars’ and 'frauds’ over in specie super contributions. And here’s what they’re going to do about it.

In a broad sense at least, the government claims to believe that SMSFs are well run, that compliance is high, and that there is little cause for concern in the sector.

They say as much regularly enough. They have said so prior to announcing every change in the sector.

Except this time.

While last week’s announcement of Stronger Super was dominated by the MySuper changes, there were two significant changes made that impact on SMSF trustees.

The government has essentially announced that SMSF trustees cannot be trusted to make in specie share transfers from their personal names into their SMSF. It intends to ban the practice outright. So it appears you will have to effectively sell the shares on the ASX, outside super, transfer the money into super then repurchase the shares.

The government’s great concern? It wants to ensure that “fraudulent activity is curbed”.

Whoa, whoa, whoa! “Fraudulent activity”? Where did that come from?

I have written a few times in recent years about the ability of trustees to do in specie transfers. The ability to do this still exists, so you may want to have a look at the most recent column.

There are two potential ways in specie transfers can be used to defraud the government (read: the tax office) when it comes to SMSFs: by timing the sale or manipulating contributions caps.

Timing the sale. An SMSF member, with assets outside super, can decide the timing of when the asset is transferred into super (either as a concessional, or non-concessional, contribution).

If the market falls, the member could choose a time when share prices are low in order to minimise capital gains tax (CGT) outside of super. That is, if BHP shares originally purchased many years ago for $20 fall from $50 to $30, the member could decide to make the in specie transfer at $30, thereby minimising the CGT to be paid by the member in his/her personal name outside of super.

The government’s problem is with when the paperwork is submitted. The paperwork should be submitted as soon as the decision is made and the transfer paperwork is signed, and the price of the transfer should be based on the share price for that day.

However, we’re talking about SMSF members and trustees and paperwork. When the government uses the term “fraudulent” activities, they are alleging that SMSF members are, essentially, backdating the transfer to a date that most suits them from a CGT perspective.

That is, hypothetically, the price of BHP falls from $50 on March 1, to $30 on June 1, but recovers to $40 by June 30.

Given the nature of paperwork when it comes to SMSFs, it is conceivable that an SMSF member/trustee could sign (backdate) the paperwork dated June 1, sometime later (even later the following financial year), when the price of BHP could have recovered to $60 or $70 (yes, I know that’s wishful thinking!)

This is called the “kitchen table rule”. That is, the members/trustees declare that the paperwork was signed on June 1, but for some reason, it sat on the kitchen table for six months before it was rediscovered. (In my house perhaps not the kitchen table, but certainly the home office '¦)

An example: Let’s assume the purchase of $80,000 of BHP shares. At their peak, they reached $200,000. A crash, like in recent months, means they’d fallen as low as $120,000. But a few months later, they’ve recovered to $200,000 again. The potential is there for members to sign the in-specie transfer paperwork to have gone through on the day the shares were worth $120,000. This would reduce the capital gain from $120,000 ($200,000 minus $80,000) to $40,000 ($120,000 minus $80,000). Some might call it “lax paperwork”. But the government is labelling it “fraud”.

Manipulate contributions caps. The other main “fraud” concern of the government is the ability to use this process to abuse the contribution caps, both concessional and non-concessional.

Let’s say that the price of a particular share stays reasonably constant for an entire financial year. For all but a few days of the year, it hovers between 95¢ and $1.05. But a short-term correction (rumour of whatever) sees the price of the share plummet to 30¢ for a couple of days, before the rumour is found to be baseless and the stock recovers to the same trading range.

Given what we’ve discussed above, the government is saying that fraud is occurring where people use this sort of occurrence to manipulate concessional contributions caps.

See this article for some of the rules on non-concessional contributions and the $150,000 a year contribution cap.

If you owned $100,000 of these shares that temporarily plummeted from $1 to 30¢, then you’ve got a potentially large advantage, if you’re defrauding the system.

Instead of making the contribution when it was worth $100,000, you could make it when it was worth $30,000. And then, instead of having $50,000 left of your non-concessional contributions cap, you’ve still got $120,000 of your non-concessional contributions cap. Do that with a bunch of shares and you could potentially have many hundreds of thousands of dollars going into super without breaking your $150,000 non-concessional contributions cap.

This can be done for non-concessional contributions for most SMSF members and potentially for concessional contributions for members who are capable of making deductible contributions.

This could be magnified during the course of a market downturn.

And, potentially, in a market upturn. If a particular share rose for the entire year, from $1 on July 1, to $10 on June 30, then the potential to “defraud” could be significant, if the trustee claimed the in specie transfer went through on July 1 when the shares were only worth $1. A parcel of shares worth $100,000 on July 1 that were worth $1 million at the end of the financial year?

What is the government going to do about it?

Follow the recommendation of Jeremy Cooper, the author of the Super System Review, and shut it down. Full stop.

Super Minister Bill Shorten has announced he intends to “introduce a requirement for related party transactions to be conducted through a market, or accompanied by a valuation if no market exists, to increase the transparency of these transactions and ensure that related party transactions are not used to circumvent legislative requirements”.

Simplified? If they are tradeable securities (ASX shares), you’re going to have sell them on the ASX, then repurchase them. The first transaction outside super to crystallise capital gains tax event outside super, the second inside super to potentially set up a CGT event for the future.

And that would massively reduce the ability to backdate the paperwork.

But the timing and, more importantly, the price, is decided by share purchase contracts, rather than a SMSF member’s “kitchen table” delay on when the transfer occurred.

Reaction?

Believe me, the detail was buried in Minister Shorten’s releases for that day (September 23) surrounding super. The mainstream press was, of course, focused on the MySuper announcements, designed to bring cheaper (dumbed down) super to the masses.

And believe me again, as a result of how it was announced, outside of a small portion of the full-time SMSF industry, you are among the first to know about this change. But if the government believes it can “slip” this one through, it’s mistaken.

The peak SMSF body, the Self-Managed Superannuation Fund Professional Association of Australia (SPAA) says there are two major issues here.

The first is that they have only targeted SMSFs. There are plenty of modern retail super funds that will allow the in specie transfer of listed assets. And Bill Shorten has not announced rule changes for those super funds.

The second is a cost and timing issue. In order to sell, then repurchase inside super, there will be costs. For small traded parcels, that might be $30 a pop, times two, to sell outside super and repurchase inside super.

And the timing issue? If you really DO NOT have the cash inside your super fund, you’ll have to sell your shares outside super (T 3), transfer the money into super (overnight), then repurchase the shares. You could be out of the market for four or five days.

And hands up those who would comfortably sit out of the market at the moment?

SPAA says it’s going to fight these changes, largely because of the unfairness of not targeting other retail super funds who will be allowed to do the same thing.

As I’ve said previously, changing the rules only opens the door to further manipulation. But in the meantime, the government has advertised a loophole.

The DIY super industry could be the next litigation minefield, as financial advisers ill-equipped to give advice start calling themselves SMSF specialists, says Macquarie Group Services director Christopher Batten. Speaking to an FS Technical Services Forum, Batten said some advisers were leaving themselves open to legal action by coining the label yet having little understanding of regulations such as insurance, CGT rules and forfeiture clauses. He said too many advisers used recommendations they learned at SMSF seminars without being fully informed of the tax or legal implications. DIY fund trustees loading their fund with property investments must be aware of pension drawdown rules, SuperIQ CEO Andrew Bloore says. If an SMSF can’t fund the 4% minimum pension drawdown from rent in a property-heavy portfolio, investments will have to be sold regardless of the state of the market. Bloore told an Institute of Chartered Accountants conference this problem could be solved where children and parents are both members of a fund, and pensions could be paid from the children’s contributions while keeping the property investments safe from a forced sale. SMSF trustees are extremely wary about equities but not so much that they are prepared to sell out entirely, a survey from the newly formed Australian SMSF Members Association has found. While 10% of polled members were not invested in shares at all, 66% of those who were said they were sitting on their equity holdings and 8% said they had sold shares recently; 36% said they had bought. The safety of cash features highly, with 23% of respondents saying they had almost two-thirds of their SMSF in cash or fixed interest investments, and 19% saying that those products made up 40–60% of their portfolios. The High Court gave SMSF trustees and large fund members a little more certainty about when their funds will arrive after it confirmed that charging employers a penalty fee for late super payments is constitutionally valid. Research company Roy Morgan challenged the superannuation guarantee charge (SGC) after the tax office said it had to pay superannuation and six years of late fees for people the company had employed as contractors. The SGC is collected by the ATO then passed on to employees, as well as their backpaid super. Finance Minister Bill Shorten said today that the SGC was designed to encourage employers to pay super on time, and that the court decision would help maintain the integrity of the superannuation system.

The information contained in this column should be treated as general advice only. It has not taken anyone’s specific circumstances into account. If you are considering a strategy such as those mentioned here, you are advised to consult your financial adviser.

Bruce Brammall is director of Castellan Financial Consulting and author of Debt Man Walking.