I’m a member, get me out of here

Exiting an SMSF is not necessarily a straightforward exercise when the fund services multiple members. Michael Hallinan examines the relevant processes.

Portability is the right of a member of a superannuation fund to transfer their interest from one fund to another. Portability is not an inherent feature of superannuation funds. Employersponsored funds did not permit an interest to be transferred unless and until the member ceased employment.

Since 1 July 2004, Part 6.5 of the Superannuation Industry (Supervision) (SIS) Regulations has provided super members with the statutory right of portability subject to some exceptions. Initially interests in SMSFs were also excluded from portability.

However, since 1 July 2018, SMSF members have had the same portability rights as members of retail and industry funds. Portability, in the context of public offer funds, does not give rise to fund stability for various reasons. These include membership size of such funds, the large net cash inflows, the ability to finance transfers from cash flow rather than asset realisation, and the relative insignificance of even large member balances among the total value of such funds. In contrast, portability in the context of multi-member SMSFs could give rise to very material issues of fund stability as these funds do not have the spread of members or significant cash inflows and each member may hold a significant portion of the total value of the SMSF.

Additionally, multi-member SMSFs are exposed to additional stability arising from the following features:

• loan liabilities arising from limited recourse borrowing arrangements (LRBA),

• holding assets that are business critical in relation to the members,

• holding lumpy assets,

• holding illiquid assets,

• having members who are business associates,

• having members who are married couples,

• having members who are family members, and

• having members in different phases of super – some in accumulation phase and others in drawdown phase.

The stability of a multi-member SMSF could be jeopardised if a member decided to exercise their portability rights, placing the fund in the position of having to find cash to implement the transfer request.

July 2004. SMSFs were excluded from the portability regime and this exception lasted until 30 November 2018. Initially a 90-day implementation period applied to transfer requests. This 90-day period was replaced by a 30-day period with effect from 1 July 2007 and finally, on 1 July 2013, a three-business-day implementation period for transfer requests via SuperStream applied, otherwise the 30-day period stood.

Simple illustration

Four partners decide to acquire commercial property from which they will conduct their legal practice and use an SMSF as the vehicle for this purpose. The SMSF is established on 1 July 2019, transfers and contributions are made, the commercial property is acquired on a geared basis using an LRBA and then leased on an arm’s-length basis to the practice operating trust.

After a few years, one of the four partners, Gerald, decides to exit the practice and terminate all involvement with the other three partners. Gerald, now having lost any sense of fraternity with his former partners, gives his notice to the partnership by fax from the club lounge of an airport and also, by another fax, to the trustee of the SMSF indicating his intention to exercise his portability rights and requests his 25 per cent share of the SMSF be rolled over to another super fund.

Of course, and unfortunately, the SMSF simply does not have sufficient cash readily realisable investments to satisfy the transfer request. So what can the trustee do?

Analysis

Is Gerald within his rights to request the transfer?

Yes, as SIS Regulation 6.33 expressly provides this right. In fact, he would provide the request to the intended receiving fund and that trustee would then be obliged to notify the SMSF, thus avoiding any unpleasantness.

Must the SMSF comply with the request?

Yes, unless an express exception applies.

When must the SMSF comply with the request?

If Gerald had submitted his transfer request to a super fund that participates in SuperStream, this fund would have to advise the SMSF by that very same system. In this case, the SMSF would have to effect the transfer within three business days of the receipt of the request. However, as Gerald made the request directly to the SMSF, it must implement the request as soon as practicable, but in any event within 30 days after receiving the transfer request.

Do any express exceptions apply?

While there are exceptions, none are relevant to the current circumstances. The SMSF could refuse the request if the receiving fund is unwilling to accept the transfer, but that is not the case here. The request could be refused if the transfer involves only a portion of Gerald’s interest, leaving the balance remaining less than $6000, but here the request was to roll over the entire interest. The request also could be refused if Gerald notified the SMSF trustees of a similar intent within the previous 12 months, but this is his first request. Finally, the request could be refused if the super interest is a death benefit income stream and the commutation of the income stream would be inconsistent with the governing rules. Again, this is not the case.

What about the illiquid investment exception?

If the illiquid investment exception applies, then the portability requirements do not. The illiquid investment exception was introduced from 1 July 2007, with a less demanding version applying to investments made before 1 July 2007 compared to that applying to those made on or after 1 July 2007.

What is an illiquid investment?

The term is defined in SIS Regulation 6.31(3). Essentially an investment is illiquid if it is of a nature that produces either of the following outcomes, namely the investment cannot be converted to cash within the portability transfer period or converting the investment to cash within the portability transfer period would likely have a significant adverse impact on the realisable value of the investment.

Does the illiquid investment exception apply?

Here the SMSF is primarily invested in a lumpy asset that is geared and is also business critical to the remaining three partners. In this context, you would think this exception would apply, however, the answer is not so simple.

For the illiquid investment exception,in the case of investments made on or after 1 July 2007, the member must have made an investment choice and before this choice was made the trustee was required to give a warning as to the effect of the exception on the portability rights, the reason why the investment is illiquid and the maximum period in which the transfer must be effected. Also, the trustee must have obtained the written consent of the member to the effect they understood and accepted a longer transfer period will apply.

Finally, the investment choice must have satisfied the requirements of SIS Regulation 4.02 if made before 1 July 2013. If the investment choice was made on or after 1 July 2013, it must satisfy the requirements of SIS Regulation 4.02A or if the fund is a small Australian Prudential Regulation Authority (APRA)-regulated fund, then it must satisfy SIS Regulation 4.02AA.

As the acquisition of the asset was made after 1 July 2018, the illiquid investment exception will only apply if the investment choice was made pursuant to SIS Regulation 4.02A or regulation 4.02AA. The former regulation cannot apply to a superannuation fund with six or former members, that is, SMSFs.The latter regulation can only apply to APRA-regulated funds with six or former members.

Consequently the illiquid investment exception can only apply to an investment of an SMSF acquired as part of an investment choice, being a choice satisfying the requirements of SIS Regulation 4.02, made on or after 1 July 2007 and before 1 July 2013.

This strange outcome arises because the amendments made to Part 6.5 of the SIS Regulations, intended to remove the exception for SMSFs, did not extend to making consequential amendments to SIS Regulation 6.34(6) to permit the illiquid investment exception to apply to SMSFs.

How should the trustees respond to Gerald’s request?

It seems the trustees would have to act in the best financial interests of the SMSF members as imposed by SIS Act section 52B(2)(c). Additionally, the trustees may have to raise equitable defences to any action by Gerald that it is unconscionable for him to demand the immediate transfer of his interest to another superannuation fund when he actively participated in the decision to acquire the commercial real estate on a geared basis. The argument for the trustees would be that implementing the transfer request would cause significant financial detriment to the remaining members of the SMSF and not be in the best financial interests of the members, including possibly Gerald. Also, given Gerald’s active involvement in the investment decision to acquire the commercial premises, including using gearing to do so, his conscience is bound not to exercise his portability rights. There would be little advantage in arguing Gerald’s involvement in the trustee’s investment decision process amounts to an informal choice as the illiquid investment exception does not apply because the decision was made after 1 July 2013.

Future action

Unless and until Part 6.5 of the SIS Regulations is amended to allow the illiquid investment exception to apply to SMSFs for investments acquired on or after 1 July 2013, the practical response of the SMSF trustees would be to clearly document the active and knowing participation of all members in the investment decision to acquire illiquid investments and that each one acknowledges the investment is for the long term, whereby a voluntary early exit of a member may cause considerable financial stress to the SMSF.

Perhaps an alternative investment structure may have to be considered for future investments. One example would be where each partner of the practice establishes a single-member SMSF where the gearing is executed at the fund level and then each SMSF purchases units in a fixed interest non-geared unit trust that only holds the commercial premises which are leased to the practice entity.