It is becoming increasingly popular for trustees of self managed superannuation funds (SMSF) to use leverage in order to magnify returns by investing in derivatives such as Contracts for Difference (CFDs). The Australian Taxation Office (ATO) defines CFDs as “synthetic financial products that enable investors to access the price movement in shares and other instruments such as stock indices, stock options, currencies and futures contracts without owning the underlying product.”
The ATO sates that a SMSF should only enter into derivatives transactions, if the purpose is to hedge and not speculate; and the SMSF has a risk management strategy (RMS) in place.
The ATO Interpretive decisions released on 29th March 2007 tries to distinguish between the two types of CFD transactions which are available in the market. One type requires the investor to place an amount on deposit with the CFD provider, and the other type requires the investor to pledge other assets of the investor.
Both types of CFD transactions are explained in detail below.
Type 1
The ATO’s interpretative decision 2007/56 states that where the purpose of the investment is for hedging only and there is no pledging of other assets of the investor, investing in CFD’s by a SMSF will be considered within the rules of SIS Act.
You can read the full ruling here ATO ID 2007/56.
The ATO states their reasoning for this as because there is no loan between the CFD provider and the SMSF trustee and therefore no contravention of the prohibition on borrowing by trustees in section 67 of the SISA. The requirement to pay a deposit and meet margin calls does not represent borrowing; they are rather contractual liabilities to make payments if and when required and are not repayments. The obligations in relation to CFDs are distinguished from margin lending through a broker's margin account in relation to the purchase of shares by an SMSF, which does represent a prohibited borrowing under the SIS Act.
The operation of the CFD bank account and the obligation to pay deposits and margins does not create a charge over any assets of the fund. The parties are relying on the contract and not on any security interest to be created by the contract. Under the CFD, the monies in the CFD bank account are the property of the CFD provider and the fund (investor) has no beneficial interest in the account. (Trustees need to examine individual product disclosure statements and contracts to ensure that there is no charge made over an asset as prohibited in regulation 13.14 of the SISR and that all requirements of the SISR and SISA are adhered to.)
The investment is in accordance with the fund's investment strategy as required under paragraph 52(2)(f) of the SIS Act and regulation 4.09 of the SIS Regulations. “
Type 2
The ATO’s interpretative decision 2007/57 states that immaterial of the fact that hedging may be the sole purpose for investing in CFD’s, if the CFD provider requires the investor to pledge other assets of the investor then investing in CFDs by a SMSF will be considered outside the rules of SIS Act. Should this occur the trustee of a SMSF has contravened subsection 34(1) of the SIS Act and has breached the prohibition against trustees giving a charge over, or in relation to, fund assets. The interpretative decision is outlined here ATO ID 2007/57.
ATO’s reasoning for this decision is:
“However the trustee and the CFD provider entered into a separate written agreement under which fund assets were deposited with the CFD provider in fulfillment of the fund's obligation to pay margins. Regulation 13.14 of the SISR prohibits trustees from giving a charge over, or in relation to, an asset of the fund. This regulation is an operating standard for regulated superannuation funds under section 31 of the SISA. Subsection 34(1) of the SISA requires that the operating standards are complied with at all times. The terms of the agreement stated the circumstances in which the fund's assets would be realised, and showed an intention to create a charge over the assets. By entering into the agreement with the CFD provider the trustee has contravened subsection 34(1) of the SIS Act.
Regulation 13.15A of the SIS Regulation, which allows trustees to give a charge over fund assets in relation to options and futures contracts in accordance with the rules of an approved body, and in accordance with the fund's derivatives risk statement, does not apply. A CFD is not an options contract or a futures contract, and the charge was not given in relation to the rules of an approved body.
The trustee has therefore contravened regulation 13.14 of the SIS Regulations and consequently subsection 34(1) of the SIS Act.
In Conclusion
As a trustee of a SMSF prior to making an investment in CFDs the trustee must consider the following:
1. Does the trust deed allow for investment in derivatives (CFD's);
2. If derivative investments are acceptable the trustee must only deposit cash as margin; and
3. There must be a Derivative Risk Management Strategy (RMS) in place.
If it is found that your SMSF is not complying with the rules your auditor may lodge a contravention report meaning that your fund may become a non-complying fund in an ATO audit.
For more helpful information on CFDs and Superfunds you can download our free CFD Guide.
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