“You can’t see the forest for the trees…
And you can’t see all the changes you’re sending me through”
— Spanky Wilson
Small business and the SMSF switch
Previously, we introduced a case study and analysed the advice provided, identified shortcomings in the advice process and proposed some alternative strategies the adviser could have considered. The case study we used highlighted some pitfalls when providing advice to an “accumulator” small business owner, particularly about contributing to super and purchasing a commercial property.
Here we’ll continue the theme by getting expert takes on 3 different aspects of the case study from:
- Mitchell Markwick, Partner at HLB Mann Judd
- Owen Evans, Lawyer at Assured Support
- Keith Henderson, Senior Consultant at Assured Support.
Mitchell, you have extensive experience working on SMSF strategies for clients. Putting on your adviser’s hat, and based on the information provided,
- which strategic approach would you see as being most suitable for the client?
- what strategic conversations are important to have with the client?
For me, the option of utilising Limited Recourse Borrowing Arrangement (“LRBA”) from a commercial lender is worthy of serious consideration, given the circumstances.
What we have in this advice is a relatively young person at 36, who won’t be able to access super for another 24+ years. The idea of withdrawing funds from his business or from his personal savings to make large non-concessional contributions would not be a sensible strategy in my view – he does not appear to have the financial capacity to make such contributions without tying up nearly all his financial resources into superannuation. Once made, the contributions are effectively irreversible.
In my view, the best option to enact the client’s objectives within the scope of the advice would likely be to:
- Rollover existing superannuation to the SMSF – $100k
- Make the recommended concessional contribution of $40k (including carry-forwards)
- Make an additional contribution (concessional if space within caps, non-concessional if not) to the fund for the remaining amount to make up a 30% deposit + Stamp duty – c~$35k
- Borrow the rest from a financial institution (not a related party loan): e.g., $350k for say a 25-year loan period (if available, depending on commercial lender conditions)
From this point the business will pay rent to the SMSF c~$30k per year (deductible to the company) along with his SGC on his wages. This would cover the monthly loan repayments within the SMSF, and he can always make top-up concessional or non-concessional contributions if necessary.
This strategy gives him the greatest flexibility to facilitate the purchase without exhausting all his available financial resources. Also, another benefit of obtaining an LRBA from a financial institution (as opposed to via a related-party LRBA) is that a longer maximum loan period is possible (e.g., for 25 years instead of 15 years for a related-party loan), meaning that the amortisation period is longer and the repayments lower – this again provides greater flexibility.
Whilst it can be argued the downside with this strategy maybe the cost of the finance (interest rates inherently higher than other loans) and the costs of establishment (the set-up costs of the SMSF itself, Bare Trust documents and conveyancing etc.), the only goal that can’t be achieved using this strategy is the subdivision.
Under an arrangement using a LRBA, and whilst the LRBA exists, the property cannot be subdivided. Only once the loan has been repaid, then the subdivision can take place and at that point, there would need to be consideration given to how the subdivision is to take place and how it can be funded – this assumes the client intends to build another dwelling on the subdivided land as the SMSF cannot borrow to do so. This is an important strategic consideration to examine further, to help the client prioritise his goals.
If adopting the above strategy, the client would still have cash available in the business entity, and that would open the discussion to strategic conversations regarding a broader range of issues such as:
- Capital requirements for the business (e.g., capital to expand and invest),
- Making prepayments where possible for tax benefits,
- Potentially paying a dividend so the client could reduce debt (subject to tax considerations),
- Investing the company cash in a term deposit or longer-term investment, and
- Reviewing whether being a sole shareholder remains an appropriate structure to retain.
Owen, you specialise in financial services law and have worked on cases involving ASIC and AFCA:
- What Best Interests Duty (BID) considerations arise when giving advice about setting up SMSFs?
- What BID issues are raised by the advice provided in the case study?
- Do you have any comments about Mitchell’s approach (above) in relation to the Best Interests Duty?
Best Interests Duty (BID) and SMSF advice
By way of summary, the Best Interests Duty requires that, at the time of the advice, the provider:
- Exercises care in objectively assessing the client’s circumstances (free from conflicts of interest); and
- Forms a reasonable belief that the client would be in a better position if they implemented the advice.
The Best Interests Duty does not require that an adviser follow the ‘safe harbour steps’ under section 961B(2) of the Corporations Act. However, as stated in the Revised Explanatory Memorandum for the Corporations Amendment (Future of Financial Advice) Bill 2012, the safe harbour steps provide “an indication of what, as a minimum, is expected from providers in order to be considered to have acted in the best interests of the client”.
ASIC provides specific guidance for licensees and representatives who provide personal advice to retail clients about SMSFs in:
- Information Sheet 182: Super switching advice – complying with your obligations (INFO 182),
- Information Sheet 205: Advice on self-managed superannuation funds: Disclosure of risks (INFO 205), and
- Information Sheet 206: Advice on self-managed superannuation funds: Disclosure of costs (INFO 206).
ASIC expects that the ‘reasonable’ adviser provider will consider things like their client’s age, dependents, intended retirement age, future financial needs and goals, insurance needs, desire to minimise fees and costs, risk tolerance, financial literacy, existing investments and tax implications before that adviser super switching advice.
Advice to set up and switch to an SMSF is considered complex advice and conversely, retail clients are, by definition, considered potentially lacking in financial literacy:
- A reasonable provider of SMSF advice will therefore be expected to be highly competent and act to mitigate their client’s potential vulnerability or otherwise refrain from advising that client into an SMSF strategy.
- This requires that advisors do not simply execute their client’s instructions but instead exercise care in assessing the relevant circumstances and ensure their clients understand the ensuing advice, including the risks of any strategy recommended.
BID and the case study
With that in mind, let’s turn to our example of an adviser who recommends that a retail client sets up an SMSF, switches existing super and makes contributions to the new fund, and if necessary utilises an LRBA to be able to purchase a commercial property.
The first consideration is about the client’s capacity to be an SMSF trustee. We do not know the specific knowledge or experience of the client in our example. However, if that client has no relevant formal education nor any relevant experience, can we be sure that client understands what a trust is? Or, what a limited recourse borrowing arrangement is?
- If we are not sure, or the answer is negative, how can we recommend that client assume potential liability as the Director of a Trustee in satisfaction of the Best Interests Duty or the obligation to provide Appropriate Advice?
- The fact that an accountant or third-party professional recommended the client pursue a given course of action does not mean the adviser can simply act as an order taker;
- Therefore, the adviser needs to demonstrate the basis by which they satisfied themselves that the client genuinely understands the long-term and material nature of the commitment.
A second consideration is how the adviser demonstrates the client understands the impact of the advice on his broader financial needs and goals, both present and future.
- The client wanted to know if purchasing commercial premises through superannuation was a good idea, which means the adviser cannot ignore the client’s broader relevant circumstances and a consideration of alternative strategies.
- By making a larger non concessional contribution to superannuation and thereby materially reducing his non-superannuation personal wealth, the client’s personal circumstances are materially changing.
- The adviser needs to show that this is reasonable and not detrimental to the client.
The advice must not only address the above concerns, but it must also be documented in accordance Section 912G of the Corporations Act as inserted by ASIC Class Order [CO 14/923].
Mitchell’s approach and the Best Interests Duty
For any given client and situation, there can potentially be many different strategies and products an adviser can recommend that may satisfy their BID obligations. That said, the process an adviser follows is important.
Mitchell appears to have taken into consideration both the broader relevant circumstances of the client (e.g., the importance of retaining flexibility and access to funds) and the specific details of the strategy (e.g., cashflow, LVRs).
This is consistent with the core tenets of the Best Interests Duty in that the adviser has exercised care in objectively assessing the client’s circumstances and has formed a reasonable belief that the client would be in a better position if they implemented the advice.
For the case study, what did the adviser need to add to the Statement of Advice (SoA)?
Clear, concise, and effective SoAs are important tools for gaining informed consent from clients.
AFCA, for example, have been very explicit on this.
Read AFCA’s views of SOA
For product replacement advice, the SoA needs to outline the material impacts of the product replacement. In the example of the case study we analysed last week, the adviser recommended the client materially change the ownership and structure of his financial assets. Therefore, the SoA needed to clearly and succinctly outline the change that was recommended, and the implications of this.
- One way to do this would be to include a comparison chart or table clearly showing the client’s net assets inside of super, and outside of super, both before the advice and after the recommendations have been implemented.
- This then highlights the loss of access to funds outside of superannuation, and the near-absolute dependence the client will have on the business continuing to succeed strongly if he is to regain or obtain a strong non-super asset position.
- Burying this detail in a cashflow chart or table in the Appendix is not sufficient: it needs to be clear and central in the SoA.
What is often overlooked when SMSF advice is provided?
“I call you up whenever things go wrong…
Things will never be the same again”
— Melanie C
Conflicts of interest:
As Owen pointed out above, to demonstrate client best interests, the advice must not be distorted by conflicts of interest:
- In the case study, the referring accountant would benefit from additional ongoing work administering the SMSF, and the adviser would potentially benefit from additional similar referrals from the accountant in future;
- Hence, to demonstrate to a disinterested person that this benefit is not influencing the advice, it is important that sufficient relevant alternatives be discussed with the client, including (where relevant) alternatives that may not result in a long-term benefit to the referrer;
- Consideration should also be given to whether the arrangement is in accordance with FASEA Code of Ethics Standard 3.
Flexibility and finance:
After implementing the advice provided in the case study, the client may struggle (given his age) to access further finance outside of super, as he would most likely not be able to use his superannuation assets as security.
- In contrast, if a commercial LRBA was utilised (e.g., in Mitchell’s proposed strategy), this would potentially have less impact on the client because he would retain more assets outside of superannuation.
- Best practice would be for an adviser to hold and document such discussions and, where appropriate, provide a referral to a relevant specialist (e.g., credit specialist) for further advice.
Licensee-Adviser agreements typically specify that advisers are only covered by the Licensee’s professional indemnity cover if they adhere to Licensee policies:
- In the case of LRBA loans or prospective LRBA loans such as in the case study, it would be prudent for an adviser to consider the Licensee’s gearing policy while preparing the SoA; the policy may require a review of insurance be conducted or other specific actions undertaken.
- If a complaint were made down the track, it is in the adviser’s interests to ensure they are covered by the professional indemnity cover!
Estate planning and asset protection
For many advisers, knowledge about asset protection and estate planning law falls into either the (to borrow from Rumsfield) “known unknown” or the “unknown unknown” categories:
- In the case study, the adviser did not document any discussions held about the impact of the client borrowing funds from his business so he could make non concessional contributions to superannuation.
- However, a loan from company to individual has asset protection and estate planning implications – there is now a potential “call” on the client by the business in the event of company insolvency.
- This may or may not be material, but informed consent and a genuine consideration of relevant circumstances imply that the adviser should attempt to identify key issues and refer the client to the relevant professional for further guidance.
The Final Word
“Sleep with one eye open. Gripping your pillow tight.”
— Metallica, “Enter Sandman”
All the above may seem a bit dramatic and regulation-heavy for what many advisers would view as a relatively simple piece of SMSF advice.
That belief is inconsistent with the reality that SMSF advice is a key area of complaints and remediation for financial advice firms – often resulting in considerable expense and a lot of wasted time.
Providing good SMSF advice to small business clients can both put the client in a much better position and provide a commercial benefit to the adviser in the form of an appreciative ongoing advice client in what can be a very “sticky” business relationship. It can be a genuinely “win-win” proposition.
Conversely, clients will appreciate an adviser who – when appropriate – steers them away from unnecessary complexity and expense.
To get this type of advice right, the adviser needs to adopt a systematic approach that demonstrates best interest duty and doesn’t focus on narrow strategies and technicalities at the expense of the clients’ broader needs and objectives.