ATO Audit of SMSF Applications

I didn't know that the Australian Taxation Office (ATO) audits applications for new Self Managed Superannuation Funds (SMSF). This guy from the ATO office in Perth phoned me yesterday and asked me a bunch of questions about my responsibilities as a trustee and the purpose of opening the SMSF and whether the admin company had approached me about opening a fund and how I picked them. He also wanted me to lodge my tax returns from 2002-07. I was in the US then and so not resident in Australia. So, I went on MyGov (the Australian government portal) and submitted a "don't need to submit a tax return" notice for each of those years. He sent me now by email an approval letter confirming that I passed the audit. Initially, I thought it was some scam when he left a message on my phone. But I checked the "switchboard phone number" on an ATO website and it checked out and so I phoned him back. The whole thing didn't sound very "professional".

Started SMSF Process

I made it my new year resolution to finally set up an SMSF. This is the next step in our financial restructuring process. The final step will be estate planning. The idea is to put relatively high tax investments into the SMSF. Also, we will put direct holdings of US stocks into the fund, so that they aren't part of our estate. Yes, there is a tax treaty between Australia and the US, which would mean that we wouldn't pay any tax at the moment. But it is likely that the threshold for inheritance tax in the US will be reduced under the Democrats and there is still paperwork to do.

I have now started the process with SuperGuardian who seem to provide a lot of service with a lot of flexibility and have very good recommendations. All I've done so far is send in the client engagement form. The decisions I made so far are to use a corporate trustee and to use a Macquarie CMA as the fund's bank account. Apparently, one third of SMSFs use a Macquarie CMA and SuperGuardian's representative said a lot of their clients do too. A corporate trustee is a little more complicated and expensive in the short run, but seems more sensible in the long run. An SMSF with only individual trustees must have at least two trustees, while the corporate trustee can have a single director. As I am 11 years older than Moominmama, it's likely that she will end up being the only trustee/director unless we bring our children into the fund, or she involves at outside person as an additional trustee. She would also have to deal with all that and she currently isn't at all interested in any of this financial stuff.

Pulling the Plug on Short-Term Trading

I've decided to stop short-term trading. In recent months it hasn't made any money, it takes up a lot of time, and it gives me a lot of anxiety. Even though I am doing systematic trading I find myself looking at the market a lot and worrying about my positions. I can't seem to stop it. And my current position sizes are quite small. After a sleepless night, I've had enough. I already cancelled my orders that were waiting to execute. I will keep the existing Bitcoin and palladium positions until they exit naturally

Going forward, I will need to think about our overall financial plan again. Trend following funds aren't doing well in recent years, so we won't want to allocate that much to them compared to the current target allocation to "futures". What should we invest in instead? Should I still plan to set up an SMSF? I delayed that while I waited to see if trading was going to be a big part of it.

I've been here a couple of times before.

All of Labor's Tax Increases

The Labor party is at the moment likely to win the next federal election in Australia in May. Labor has become increasingly left wing in recent years and has a long list of policies to raise taxes. This is, I think, a comprehensive list:

1. Abolish Liberal plan to raise the top tax threshold to $200k: This was supposed to happen in 2024. The top tax bracket will still cut in at $180k (about USD130k) where it has been for many years. Bracket creep is pushing more and more taxpayers into the top bracket. This will affect us if I am still working then. If I'm not, probably my taxable income will be lower.
   
2. Raise the top tax rate: Add 2% to the top rate to raise it to 47%. With Medicare that is 49%. This will immediately raise our taxes.
   
3. Abolish plan to eliminate 37% tax bracket: This also was supposed to happen in 2024, so may not affect us except to the extent of how many franking credits will get used up offsetting our taxes, if I retire by then.
   
4. Repeal already-legislated tax cuts for companies with turnovers of between $10 million and $50 million: Small businesses pay 27.5% corporation tax and larger companies 30%.  The government wanted to extend the low rate to larger companies. This is unlikely to directly affect us.
5. Reduce the long-term capital gains tax discount to 25%: The discount is now 50%. This will have an immediate impact on us as we have run out of accumulated tax losses. OTOH existing investments will be grandfathered. It makes it more attractive to incorporate and pay CGT of 27.5% instead of 37.5%.
   
6. Abolish refundability of franking credits: Since 2000, if you have excess tax credits from Australian companies beyond those that offset the taxes you need to pay you can get a cash refund. I did benefit from this once or twice soon after we moved to Australia and my income was low. This will have a big impact on superannuation funds in pension phase that have zero tax to pay and possibly even in accumulation phase if they have a lot of franked dividends. It will affect lower income self-funded retirees with money outside superannuation too.  Some listed investment companies (closed end funds) are already paying out special dividends to get franking credits out of the fund and to investors before the end of the financial year. On the other hand, I don't think these funds will radically restructure due to this proposal. I don't think it will have a big impact on us as I've planned to put the least tax advantaged investments like managed futures into our planned SMSF. And I expect we would be in the 32.5% tax bracket when retired. If I retire at 60 say and start a superannuation pension we could use franking credits inside our SMSF to offset Moominmama's superannuation earnings tax liability as she is 10 years younger. And then maybe we could add Moomin to the superannuation fund :)
7. Abolish negative gearing: This is the ability to deduct investment costs beyond the earnings of an investment from other income. This mainly applies to property investors who mostly lose money in Australia in the short run, hoping for a long-run capital gain. We don't negative gear so it shouldn't affect us. Wealthier property investors who also own shares or other investments will be able to offset their losses in property against dividend and other income. So, like many of the Labor measures they mainly hit lower income investors...
   
8. Tax discretionary trusts as companies: These are trusts that have multiple beneficiaries and can alter what earnings they stream to which beneficiary on a year by year basis. Actually, they are proposing to tax trust distributions at a minimum of 30%. So, it's not like a company which pays 27.5% tax in the case of a small business and then distributes franking credits. I don't see any justification for allowing this kind of tax dodging. However, I think they should just require all trusts to be unit trusts with defined shares and everyone sharing in all income. These operate just like unlisted managed funds (mutual funds). I think most discretionary trusts will just do this if it's allowed.
   
9. Reduce annual non-concessional superannuation contributions to $75k: This would mean it would take us more years to make all the non-concessional contributions we want to make and means I probably should already get one in this financial year.
   
10. Reduce the threshold for 30% superannuation contributions tax to $200k: Currently the threshold is $250k. The threshold includes employer superannuation contributions, so this will definitely affect me.
    
11. Remove the right, already legislated by the government, of superannuants to make catch-up contributions when their super balance is less than $500,000: I don't think this is probably a big deal. It will mean stretching contributions over more years.
    
12. Reduce ability to take tax deductions for additional concessional superannuation contributions: People will need to have 90% of their income or more from sources other than employment to do this. I don't understand why concessional contributions for employees are limited to salary-sacrificed contributions and you can't make more concessional contributions unless you really aren't an employee. The Liberals tried to fix this anomaly.
13. Limit tax free pensions to $75k per year: Currently you can transfer up to $1.6 million into an account to fund a tax free superannuation pension. At a 4% initial withdrawal rate (required rate for under 65s) that is $64k per year. At 5% (65-74 y.o.) it is $80k per year. So, Labor's proposal is not that restrictive. However, if the $1.6 million earns a lot more than that a year, it will be taxed a lot more than at present.
14. Limit deductions for tax advice to $3,000 per year: I am assuming that this won't apply to companies or superannuation funds, just to individuals. In which case, it isn't a big deal.

I think most people are probably aware of one or two of these but don't have a good idea of the extent of the proposed tax increases. A big question is whether Labor will have sufficient control of the Senate to pass all these measures.

Crowdfunded Real Estate

A relatively new investment concept is crowdfunding real estate investments. The idea is that an individual could directly invest small amounts in a range of properties or development opportunities thus reducing their risk. Rather than a fund manager picking the properties, investors could evaluate deals themselves.

I read about Fundrise on Financial Samurai. It seems to actually be closer to a traditional unlisted real estate managed fund, except there is more of a property development angle. They allow investments in both real estate debt and equity. They claim very high historical rates of return. I find it hard to understand how they could be so high. Equity investments could have leverage but debt investments must return the interest rate on the mortgage minus costs? I didn't feel that there was enough transparency around how returns are generated. In any case, unfortunately, it is not open to non-US investors.

So, I looked for crowdfunded real estate opportunities in Australia. This is what I found:

Crowdfundup – I only found one active project on the site.

Estatebaron – This website has more active deals. It focuses exclusively on property development. There seems to be very little information about each project and the site is much less polished.

Brickraise – The link seems to be dead.

Domacom – This is an ASX listed company. The company looked like they were heading to bankruptcy before a recent fundraising. The new money will only last just over half a year as their burn rate is AUD 5 million a year. They will need more than AUD 0.5 billion assets under management to break even given a 0.8% of NAV management fee. However, they have the largest number of deals on their site and have high quality information. Deals include a wide range of projects including solar farms and bioenergy as well as more conventional real estate. This is something I might consider when we have an SMSF up and running if it looks like the company will survive.

Based on this, real estate crowdfunding is not well developed in Australia. Do you know of other better websites?

Will Listed Investment Companies Restructure if Labor Eliminates Refundability of Franking Credits?

As you probably know if you live in Australia, Labor plans to abolish the refundability of franking credits - the tax credits attached to dividends for company tax already paid. This will affect taxpayers with low marginal tax rates including self managed superfunds that are paying out a pension, which is tax free if they have less than AUD 1.6 million in assets for that member. This could significantly cut the retirement income of self-funded retirees who have a lot of Australian shares. OTOH, this was the policy prior to 2000 and most other offsets, like foreign tax credits, aren't refundable either.

I already plan to have relatively small amounts of Australian shares when I start an SMSF - this makes sense as I have lots of investments outside super and so it makes sense to put the least tax efficient investments like managed futures into super.

Listed investment companies (LICs) are closed-end funds that pay tax on their earnings and then distribute franked dividends to shareholders. I own shares in several of these like Platinum Capital, Cadence Capital, Hearts and Minds, and Tribeca Global Resources. Both Geoff Wilson and Cadence Capital's Karl Siegling have suggested that they will reorganize their funds if this happens. There are a couple of ways this could happen. One I had thought about, is to delist and turn the fund into a unlisted managed fund (mutual fund). For funds that trade at a premium to NAV, like several of Wilson's funds, this would cause investors to lose a lot of money as now their holdings would only be worth the NAV. For funds trading at a discount to NAV it could be attractive, as shareholders would gain wealth (but see below). To the extent that the funds receive franked dividends from companies, they would still have to distribute franking credits, but capital gains would no longer create franking credits.

Another option I didn't know about, is that they could instead convert to a listed investment trust like an ETF that doesn't pay taxes. This solves the problem of wealth destruction for funds trading at a premium to NAV.

But the article I linked says that this would result in realization of the portfolio for tax purposes. This could be a huge tax bill for companies like Argo that do little trading. The funds will need to pay out a massive special dividend to distribute the associated franking credit. According to Argo's website they will need to pay 72 cents in tax for liquidating the portfolio. That means they would have to pay a $1.68 cash dividend and so actually sell 23% of the portfolio to pay the dividend out. Some other funds have undistributed franking credits and so would also need to sell shares to generate the cash for such a dividend. They will need to do this soon, as there will probably be an election next May. So, I am a bit skeptical that many will.

Self Managed Superannuation

I am exploring setting up a self managed superannuation fund (SMSF). I want to do this so that I can implement our target portfolio investment strategy and so I can put higher tax investments into the lower tax superannuation environment. Managed futures are a tax ineffective investment outside super when your marginal tax rate is 47%. Inside superannuation they will be taxed at 15%.

Setting up an SMSF is very complicated in Australia compared to the US where you can just open an IRA account with a broker like any other brokerage account and the only issue is limits on contributions and later on minimum withdrawals. For standard IRAs you pay tax on withdrawals only, on your regular tax return. The main reason Australian SMSFs are complex is taxation but some of the bureaucracy just seems to be for the sake of it... In Australia, pretax or concessional contributions are taxed at 15% (or 30% for high income levels) going in, and you can also make after tax contributions. Its necessary to keep track of which were taxed how. Then earnings are taxed at 15% (10% for capital gains) and can be offset by franking credits and foreign tax paid. When you finally withdraw your money, no tax is due and earnings of the account are untaxed if you set up a pension, though now there is a cap of $1.6 million on the amount of assets whose earnings are untaxed. So funds need to submit tax returns separate from their members. And they need to be audited annually and there are lots of ways they could become non-compliant with the rules. And an SMSF is a trust which is set up as a separate legal entity. You might also want to set up a company to act as trustee!

You could go to a lawyer to set up the trust and to a local accountant to help audit the fund and do everything else yourself. But there are many providers who streamline the set up and administration of SMSFs. You can get "year-end" administration which just helps get everything in order for the tax return and audit, or you can get a full daily service. Though I do our own tax returns, I have decided to go for the full daily service as I want to outsource this as much as possible (looks like I am going to have to do tax returns for my son too and am also looking at setting up a company...) and want to be confident that I am compliant with the rules, because the penalties for non-compliance are very severe.

This is a great site with information about different providers of services for self-managed superannuation funds. I visited the websites of all the providers that offer a daily service. Some sites have a lot information and some have next to none. The latter want you to phone them to give you the details. I have a strong preference for financial services that are as transparent as possible. I also investigated Commonwealth Securities and Dixon Advisory, which are not on this list.

Dixon are based in Canberra and I often go past their offices on Northbourne Avenue. Years ago, I used to read Daryl Dixon's column in the Canberra Times. Their service combines admin and investment advice and costs from $3,000 for a $333k account to a maximum of $6,000 for accounts above $666k. To make investments, you have to call their broker and the commissions for shares are 1.1%, which is capped at $400 for Australian shares and uncapped for foreign shares. I don't need investment advice and trading is way too expensive.

Commonwealth Securities is a more realistic option. Including audit fees, they charge a flat $3,000 a year. On a $900k account that is 1/3%, which is reasonable. Trading fees are 0.12% for Australian stocks, which is good though not the lowest, and 0.31% for US stocks and 0.41% for shares in the UK and many other countries, which is expensive but not as outrageous as Dixon. You can't trade CfDs (which are offered by CommSec for other accounts) or futures (which aren't offered by CommSec).

You can set up a trading account for an SMSF with Interactive Brokers, which can trade anything you like for low fees, and then find an administration provider who is prepared to work with them. Determining who can work with IB is what I need to do next. You can trade futures in an SMSF as long as it fits within the written investment strategy (yes, you are required to write one) and other risk related rules.

Two providers on my list, who have won awards and who I am going to investigate next, are Heffron and Super Guardian. I am impressed with the transparent information on Super Guardian's site. They also have an endorsement from Chris Cuffe. Super Guardian charge more the more investments you have. If we have up to 20 investments then they are a similar price to CommSec. Heffron charge a flat fee of $3,300 for their top level service.

Longer Term Planning

I was rejected for the two jobs I recent applied for. One in Australia after interview and one in the UK pre-interview. So, it looks like we stay in Australia in this city for the moment. It also looks like I will continue in my job next year, but I am seriously thinking about "retiring" at the end of 2019 when I will be 55.

Hopefully, the probate situation is finalized before the end of this year and we can start to restructure our finances. This is what I am thinking to do:

1. We will need to set up a trust account or something less formal for little Moomin for the relatively small amount of money he will inherit. Need to wait to hear what we need to do. According to the will, he won't get the money till he's 23 years old...

2. Almost pay off our mortgage and then redraw it and use it to pay off margin debt and add to a trading account. We can then deduct the mortgage interest from our taxes and it is a lower interest rate than the current margin loan.

3. Set up a self-managed superannuation fund (SMSF) and roll my existing Colonial First State superannuation fund into it as well as contributing AUD 300k for each of me and Moominmama. This would then have about AUD 900k to start with. The reason to go down the road of self-managed super is to be able to invest in managed futures, which are a tax ineffective investment outside super. We would put all our high tax investments into the fund as well as some Australian shares with franking credits to reduce the tax.

4. Scale trading up to full size. At the moment, I am thinking we will need to set up a company for trading. Corporation tax on small businesses is 27.5% vs. top personal marginal rates of 47% +.* My understanding is that you don't need to pay out all profits as dividends and so retained earnings are more lightly taxed. But I will need advice on this. It would also protect the rest of our assets against something catastrophic happening. The company could also be the trustee for the superannuation fund, which would allow us to maintain the SMSF if we left Australia.** These are just my current understandings – obviously I am going to need to get professional advice on all of this.

5. Estate planning. Currently we don't even have wills. This is an area I know little about but will need to deal with. What I want to avoid is the situation we faced with my mother where the government dictated investment policy to us after she wasn't capable of making decisions - despite giving us power of attorney.

* The downside of companies is that they don't get a capital gains tax discount. Individual investors in Australia only pay half the marginal rate on capital gains on investments held for more than a year. But the advantage of only paying 27.5 or 30% tax on trading income rather than 47% tax before investing it in other investments outweighs the discount. If Labor reduce the discount, this will be even more the case.

** You can't be the trustee of an SMSF if you aren't resident in Australia. Using a corporate trustee gets around that. There is a problem in leaving Australia and receiving income through an Australian company as it means we would suffer from double taxation. In Australia, dividends from the company would have attached franking credits so that we would only need to pay the difference between 27.5% and 47% on dividends. But if you live outside Australia in a location where you need to pay tax on foreign income (obviously one reason to move might be to reduce tax...) then we would need to pay the foreign tax on top of the Australian company tax. Investments already inside the company are invested in Australian stocks that pay franked dividends, then the franking credits on the dividends received would mean that the company wouldn't pay net tax on its investment income, so that won't be double taxed if we moved overseas. But trading income would be taxed at 27.5% and then again if paid out as dividends. So, we would need to do a restructure in the most tax-effective way at that point. In an earlier version of this post, I did think about having the company being the beneficiary of a discretionary trust that actually did the trading and then just changing the flow of income. But the trustee of the fund has to pay tax for offshore beneficiaries. So, that doesn't help.

Target Portfolio

Following up on my previous post where I tested the performance of an idealized portfolio, here are some more ideas about an actual implementation. In total, 50% would be allocated to stocks, half of that Australian and half of that international. A fifth (maybe more) of the Australian category would be allocated to small cap stocks. Of the remaining 20% portfolio allocation half would go into unhedged funds/stocks and 10% into hedge fund type funds, probably mostly listed hedge funds, such as Cadence Capital (CDM.AX). Of the 25% in international stocks, half would go into hedge funds, primarily Platinum Capital (PMC.AX), which pays franked dividends. Then 25% is allocated to managed futures, probably mostly Winton Global Alpha Fund. This should mostly be held in a superannuation account for tax reasons – pay 15% tax on distributions instead of 47%. That means I am going to need a self-managed superannuation fund.

5% is allocated to gold. This would be held in a taxable account as it doesn't pay dividends. On the other hand, the long-term capital gains rate in superannuation accounts is 10% (and zero after going into pension mode) and my current long-term capital gains rate is 23.5%. If Labor get into power, which is likely, and implement their program, which is less likely, that will rise, though in retirement I expect my marginal tax rate will fall back into the 32.5% bracket but with Medicare tax and Labor's proposal, I would still be paying more than 25% for long-term capital gains. So it makes sense to get more money into superannuation, which is zero taxed in pension mode for the first $1.6 million for each partner. I plan to initially invest about $900k in the SMSF. This will come from rolling over my superannuation fund now at Colonial First State and adding $300k - you can invest 3 years of contributions at once - for each of Moominmama and myself.

The remaining 20% is allocated roughly equally to (mostly direct - i.e. not listed) real estate, bonds, private equity, and cash. Then the whole thing is levered up a bit, with the overall exposure adjusted for market conditions. I expect that debt will be roughly equal to the value of our house ($840k).

To summarize, this is the asset allocation (not including our house):

We are quite a long way from that - in particular very overweight long Australian shares and underweight hedge funds, managed futures, and gold.

Guardianship

My mother suffers from dementia. Up till recently my brother had power of attorney to make financial decisions for her, but financial providers now wanted him to have guardianship. So he is now the official guardian but the guardianship office where he and my mother live says that her investment portfolio is too risky. They want us to not have more than 20% in equities, get rid of all alternative investments and have the rest in cash and AAA bonds. It is not as if my brother and I decided on the current allocation. It's not a lot different to how it was when my mother could make her own decisions. The problem is that cash earns almost nothing anywhere and short term bonds less than inflation. Long-term bonds have the risk that their value will fall when one day central banks raise interest rates again.

We have tried to resist this and the guardianship office people met with my brother and his lawyer but the only concession they made was to give us a year to sort it out. In the meantime we also discovered (I read about this in an article in the New York Times) that the inheritance tax free threshold in the US for foreign estates was only $60k. That means that around 40% of the money in the US based separately managed accounts in my mother's name would be taxed away after she died - the accounts had minimal if any profit - so it would be taxing savings rather than earnings. So, we closed those accounts avoiding US inheritance tax and reducing the equity share of the portfolio to about 20%. Anyway, this is a warning to get good arrangements in place while you are still capable of making your own decisions rather than having a court imposed solution.

I need to think also about how to avoid US inheritance tax. I only have about $60k of direct US investments in stocks and mutual funds. But I also have another $70k in a 403b retirement account (TIAA-CREF). So, if I suddenly died there would be about $30k in inheritance tax that Snork Maiden would have to pay (no spouse allowance for foreigners...).  There are various options including trying to roll my 403b into an Australian super fund now or setting up an Australian self-managed super fund (SMSF) and transferring the US individual investments into it. My thinking is that this would then be like having units in an Australia based managed fund. Would need to get proper advice on that first. Of course, it's not worth setting up an SMSF for just USD 60k in investments - that would be just one of the holdings of the SMSF. So, watch out if you have individual stocks in the US and aren't a US citizen.