By Graeme Colley

In some SMSFs you may have members with personal investment portfolios within the fund. This may be due to their age, risk tolerance or current personal situation. Take for example, one member who has a high risk tolerance and favours growth investments and another who may consider a more conservative investment approach and favours bonds and term deposits. So, is it possible for each to have a tailored portfolio within the fund? The answer is ‘yes’ it is possible – but there’s an increased level of complexity in running the fund and some other things to consider.

What does the fund’s trust deed say?

The fund’s trust deed must permit the allocation of investments to members’ accounts. The deed should say something along the lines that the trustee, as agreed with the member, may acquire or allocate investments for the member’s benefit, providing it is consistent with the fund’s investment strategy. The deed may also say that the investment will be held for the specific benefit of the member and recorded in the member’s account. This will allow the investment to be segregated from other fund investments held for other members and those held for general fund purposes.

The transfer of the investment from the member’s account may be subject to their approval. In addition, the deed may say that no other member may obtain an interest in the investment unless it is transferred to the member for purposes of paying a benefit or the asset is sold to pay a benefit.

What does the superannuation law say?

The legislation allows a member of an SMSF to direct the trustee in exercising their powers under the trust deed. This can include directing the trustee how, when and where a member’s benefits are paid or directing the trustee to acquire and dispose of investments which may be held for a member.

Are there any drawbacks with investment allocation?

Separating assets may keep member’s happy as they know exactly which investments ‘belong’ to them. However, there are a number of things to consider – mainly accounting-related issues associated with the allocation of income, expenses and tax. This is where things become more complex.

From a tax point of view the total income earned by the fund from each member’s investments is aggregated to determine the fund’s taxable and exempt income. Depending on the proportion of the fund that is in accumulation and retirement phase the fund’s taxable and exempt income can be calculated by using either the unsegregated/proportional method, or in some cases the segregated method .

Just like all taxpayers, the fund can claim tax deductions for expenses which relate to its taxable income and special deductions available only to superannuation fund. Also, any tax credits from income earned by the fund, whether taxable or tax-exempt, can be applied against the fund’s tax bill. Therefore, to be accurate in calculating the net income for each member’s allocation of investments, a separate calculation may be required which may be complex.

The other drawback relates to the cash flow of the fund and its ability to pay benefits and expenses when they become due. Where investments allocated to specific members and the fund’s cash flow is not being properly managed, a member’s investment allocation may not be able to make pension payments as required. So, a degree of skill and care is needed here.

Case study:

Two individuals are members of an SMSF. The fund’s trust deed allows members to select investments as agreed with the trustee. One member is in accumulation phase, is a more conservative investor and has selected bonds and term deposits. The other member, who is in retirement phase, is a more aggressive investor and has selected ASX listed shares which are fully franked.

The fund is using the unsegregated/proportional method to calculate its taxable and tax-exempt income. As 50% of the fund’s investments are in retirement phase, 50% of the fund’s total income is taxable.

During the year the fund earned $30,000 interest from term deposits and $35,000 in dividends with franking credits of $15,000. The fund will pay 15% tax on its taxable income $40,000 (50% of the fund’s total income of $80,000) which is $6,000. After applying the franking credit of $15,000 the fund will receive a tax refund of $9,000. This means that the franking credits received on the investments of the member in retirement phase has been used to pay the tax earned on the other member’s bonds and term deposit in the fund.

Outcome:

• With the tax payable by the fund, an adjustment will be required to the member whose account balance is in accumulation phase to be reduced by the amount of tax that should have been paid on the income earned from the term deposit ($4,500).
• The account balance of the member in retirement phase should be adjusted and take into account the tax benefit the fund received from the franking credits less tax paid due to the proportion of the fund in accumulation phase which is taxable.

Summary – what you need to consider

If anyone looking to separate investments within an SMSF probably needs good advice. Here’s some of the things to consider:

• Does the fund’s trust deed allow member investment choice?
• Are there good reasons to split the investments based on member investment choice?
• Does the investment strategy recognise member investment choice?
• When allocating income on the investments for each member’s account, are expenses allocated on an agreed basis?
• When calculating the taxable income for the fund are adjustments made to the members’ respective accounts to take into account franking credits, permissible tax deductions and other expenses?

And finally … another option to consider

To be practical it is worthwhile to consider having two SMSFs, one for each member. This could have the same effect as investment separation within a single fund, but with less complexity and maybe less cost. If the proposed increase in the minimum number of members of an SMSF increases to 6 think of the complexity of allocating investments across each member’s portfolio – a potential nightmare.