Although they are highly speculative, cryptocurrencies have experienced a surge in popularity amongst investors. With investors seeking out ways to get their hands on Bitcoin, Ripple and other cryptocurrencies – whether they can be accessed through super has become a common question.
The trustee of a Self Managed Super Fund (SMSF) must make investment decisions and continuously monitor them to ensure they serve the best interests of members. The investment decisions must also comply with the SMSF’s investment strategy and be in accordance with superannuation law.
Earnings by a super fund on investments which are arms-length income are taxed concessionally. However, earnings which are considered non-arm’s length income of the super fund (NALI) – which the Australian Tax Office (ATO) has highlighted as an issue when an investment is financed by a related party loan – are taxed at the highest marginal rate.
In determining whether income from an SMSF’s investment in cryptocurrency is NALI – two questions must be asked: can the SMSF invest in cryptocurrency in the first place? And, can the SMSF borrow for such an investment?
Does the SMSF’s trust deed allow investment in cryptocurrency?
The trustee of an SMSF must assess investments in cryptocurrency in the same manner as any other investment. The trustee’s considerations include:
- whether the SMSF’s trust deed authorises the investment
- the nature of the investment and the risk appetite of the members
- whether the investment fits into the SMSF’s investment strategy
- how does the SMSF take and hold title to the asset.
Is it prudent?
Assuming that an SMSF may invest in cryptocurrency – and has a suitably prepared investment strategy – the SMSF trustee must consider whether such an investment is consistent with the trustee’s obligation to act as a prudent superannuation trustee. For example:
- Cryptocurrencies are not generally well understood in the general population: do the trustee and members understand them? Do they understand how, or the extent to which, cryptocurrencies may be affected by future international regulation?
- Cryptocurrencies trade on exchanges which are not well regulated nor transparent: will the SMSF be able to realise its investment when the time comes?
- Will the SMSF’s investment be well protected from other threats which are amplified in the case of unregulated synthetic investments, for example the loss of investments because of cybercrime.
- Do the trustee and members truly appreciate the volatility of the market? In the case of Bitcoin, this has seen prices range from $928.23 (as at 31 January 2017), to $19,184 (as at 16 December 2017) to $11,034 (as at mid-January 2018).
Can an SMSF borrow to invest in cryptocurrency?
SMSFs are permitted to borrow only under a limited recourse borrowing arrangement (LRBA). If the terms of the LRBA are on non-arm’s length terms, then income generated from the assets acquired from the borrowed funds risks being considered by the ATO as NALI and therefore taxed at the highest marginal rate.
When will the ATO treat dealings as being on arm’s length terms?
The ATO will only treat dealings as being on arm’s length terms if the arrangements reflect what might be expected to have occurred if the parties to the scheme had been dealing with each other at arm’s length. For example:
- the ATO’s Practical Compliance Guideline, PCG 2016/5, contains safe-harbour terms for related party loans which, if reflected in the relevant transaction documents, will ensure the NALI consequences do not apply
- the parties must otherwise determine what terms would have been offered to the SMSF trustee by an unrelated third party lender (e.g. a bank).
So apart from the safe-harbour provisions, how will the ATO assess whether the arrangement is on arm’s length terms?
When assessing whether an arrangement is on arm’s length terms, the ATO will assess whether the SMSF has derived more ordinary and statutory income under the scheme then it might have been expected to derive if the parties had been dealing with each other at arm’s length regarding the scheme.
In order to determine what the parties might have been expected to derive had the parties been dealing with each other at arm’s length (hypothetical situation), one must identify:
- the steps of the relevant scheme
- the parties to the scheme
- the amount of ordinary or statutory income that the SMSF might have been expected to derive if the same parties to the scheme had been dealing with each other on an arm’s length basis
- the terms of the borrowing arrangement under the hypothetical arrangement, such as:
- the interest rate
- whether the interest rate is fixed or variable
- the term of the loan
- the loan to market value ratio.
Once the hypothetical situation has been determined, it is necessary to consider whether the SMSF would have or could have entered in to the hypothetical borrowing arrangement as follows:
- If the SMSF could not have or would not have entered in to the hypothetical arrangement, then ALL the ordinary or statutory income from the related party arrangement will be taken into account in assessing the SMSF’s exposure to a NALI assessment.
- If the SMSF could have and would have entered into the hypothetical arrangement, then the NALI provisions may apply to the assessment of tax on the SMSF’s taxable income, but only to the extent that taxable income is more than it would have been under the hypothetical situation.
Factors the ATO considers concerning whether the SMSF ‘could have’ include:
- whether the SMSF’s deed imposes any impediments and allows the borrowing arrangement
- whether the SMSF has sufficient capital available
- the ability of the SMSF to service the arm’s length terms
- any legislative or regulatory impediments which might prevent the SMSF from acquiring the asset.
Factors the ATO considers concerning whether the SMSF ‘would have’ include:
- whether the borrowing arrangement was consistent with the SMSF’s investment strategy
- whether the borrowing arrangement was the optimal use of the SMSF’s funds
- whether the borrowing arrangement, taking into account future income and capital gains, would be earnings accretive.
How do these NALI considerations apply in the case of cryptocurrencies?
The issue for an SMSF is identifying a defensible hypothetical scenario: that is, can one conceive of an arm’s length lender providing a loan to an SMSF to invest in cryptocurrency?
The same reasons that a prudent SMSF trustee may be reluctant to invest in cryptocurrency, apply to whether a bank, being an arms-length lender, would lend money to an SMSF for an investment in cryptocurrency. In addition to the fact that cryptocurrencies are currently unregulated and operate in a volatile market, lenders’ concerns would be amplified by:
- the unregulated nature of these investments, which means there is uncertainty surrounding whether and how the lender will be able to enforce its security in the cryptocurrency in the event of default
- the fact that lending to SMSFs must be limited recourse – so the lender is directly impacted by the volatility in the price of the currency.
Therefore, even if the SMSF can demonstrate that it ‘could have’ and ‘would have’ invested in cryptocurrency (by reference to the factors set out above), if the SMSF cannot establish a hypothetical scenario, then the SMSF’s income from its investment in cryptocurrency will be exposed to an assessment as NALI.
Given the above, a decision to borrow money to acquire cryptocurrency through an SMSF should not be taken lightly as it is unlikely to achieve the desired outcome of tax savings. Individuals should consult their advisors before taking any steps.