David Ward highlights the growing need for professional advice on PAFs and the key differences between these trusts and SMSFs.
Self-managed superannuation funds (SMSFs) have become the fastest growing and largest sector of the superannuation industry (with more than $400 billion in assets). Less well known is that with almost 1000 private ancillary funds (PAFs) now collectively managing more than $2 billion in funds, these trusts have rapidly become the primary vehicle for family philanthropy in Australia. The sharp growth in both of these trust structures in recent years partly reflects the strong impetus by individuals and investors to control their own finances. With superannuation a top-of-mind issue for many clients, most financial planners are well-informed about SMSFs. But, with growing numbers of high net worth clients who are seeking advice on philanthropy, it is also becoming increasingly important for advisers to understand how to structure and manage PAFs. Both SMSFs and PAFs are trust structures with funds that are invested over a long time horizon; but they have slightly different compliance requirements, as summarised below.
While SMSFs are largely aimed at investors building wealth for retirement, PAFs are used to accumulate a corpus solely to distribute to community organisations over time. The PAF structure is designed for donors who are seeking control over their investment and grant-making decisions, and they offer donors several advantages, including tax deductions on contributions. (See the July 2011 edition of Professional Planner for the differences between PAFs and other philanthropic structures.) DIRECTORS/RESPONSIBLE PERSON Whereas all members of an SMSF must be trustees, either as individuals or directors of a corporate trustee (and SMSFs are only permitted to have up to four members), the recent changes to the PAF rules in October 2009 have meant the trustee of a new PAF must be a company, rather than individuals. PAFs can be managed by a founder and their family, because the directors of the company can include family members.
However, at least one of the directors of the company must meet the ATO “responsible person” criteria, and that person must be independent of the founder; that is, not be the founder or major donor or an associate of either. TAX SMSFs are taxed at 15 per cent in accumulation mode (on income and concessional contributions) and are tax exempt when in pension mode. PAFs also offer a number of tax advantages. Not only is the PAF structure itself income tax exempt irrespective of whether funds are being accumulated or spent, but donations to the PAF are also usually tax deductible to the donor, with deductions able to be spread over a five-year period. However, donations must not create a tax loss for the donor. INVESTMENT STRATEGY For both SMSFs and PAFs there is a fiduciary duty on the trustees/directors to carry out stewardship of the fund assets prudently. Because there are different tax rates applying to SMSFs depending on whether they are in accumulation or pension mode, this will affect their investment strategy during these different phases. The investment strategy for a PAF is similar to that required for an SMSF, but because of its tax exempt status, the PAF investment strategy should focus on after-tax returns.
Both SMSFs and PAFs tend to favour direct share investments, due to the benefits associated with refunded franking credits. (See the September edition of Professional Planner for more detail.) The trustee of a PAF is required to prepare and maintain a current investment strategy for the PAF, which includes the investment objectives of the PAF and indicates the investment methods that the trustee proposes to adopt to achieve these objectives. INVESTMENT, RELATED PARTIES AND VALUATIONS While PAFs cannot purchase collectibles (and any donated must be sold within 12 months), SMSFs are permitted to hold art and collectibles. However, SMSFs with this asset class are now subject to stringent rules for purchases made after July 1, 2011, but existing holdings benefit from transitional arrangements until July 1, 2016. PAFs are not allowed to run a business. And, any related-party investment transaction by the PAF must be by way of an arm’s-length transaction on commercial terms, or terms more favourable to the fund.
The buying and selling of related party assets for SMSFs is now also subject to a more formal process (and must be made via an underlying market or through an independent valuer). SMSFs can be in receipt of equities in the form of in specie transfer at market value (that is, at the listed closing price on the ASX for these stocks). The individual making a contribution to an SMSF via in-specie transfer is subject to capital gains tax to the extent the market value of the transfer exceeds its cost base, after any applicable discount. This process is different for PAFs in that any non-cash donation of more than $5000 must be valued by the Australian Valuation Office (AVO) – a subsidiary of the Australian Taxation Office (ATO) – and the income tax deduction is based on this valuation.
The AVO will value the equities at the time of transfer (that is, on the day that it took place), but the exact valuation will not be known for some time, and there is a fee. As with transfers into SMSFs, asset donations to PAFs may have CGT consequences for the donor. PAFs are required to estimate the market valuation of their (non-land) assets at least annually and of land at least every three years, and SMSFs are likely to be subject to similar rules in the near future. AUDIT AND BORROWING Both SMSFs and PAFs are required to keep financial accounts and have their financial statements audited each financial year. PAF auditors must be registered with and approved by ASIC and similar rules are likely for SMSFs. For PAFs the audit must be not only of the financial statements but also of compliance with the PAF guidelines. While borrowing by SMSFs is currently allowed in limited and restricted circumstances, borrowing by PAFs is prohibited – with only a few exceptions.
