How low can your interest rate go? SMSF related party loans

SMSFs are allowed to borrow from a related party

The ATO states that the law does not prohibit the lender from being a related party. However, SMSFs must continue to comply with other legislative requirements. For example, the SMSF must satisfy the sole purpose test and comply with existing investment restrictions such as those applying to in-house assets and prohibitions on acquiring certain assets from a related party of the fund.

To know whether it is acceptable for related parties to lend to an SMSF on favourable terms, including 0% interest rates it is necessary to consider the full implications of the non-arm’s length income provisions in section 295-550 of the Income Tax Assessment Act 1997 (Cth).

Non-arm’s length income provisions

Broadly, income is non-arm's length income of a complying SMSF if:

• it is derived from a scheme or investment in which the parties were not dealing with each other at arm's length, and
• that amount is more than the amount that the SMSF might have been expected to derive if those parties had been dealing with each other at arm's length.

"Non-arm’s length income" is taxed at 45%.

ATO's position

The following comes from minutes of the June 2012 National Tax Liaison Group as tabled at the December meeting:

·        The ATO position on low rate loan arrangements and LRBA is that that they do not generally invoke a contravention of the SISA, do not give rise to non-arm’s length income under section 295-550 of the Income Tax Assessment Act 1997 (ITAA), do not invoke Part IVA of the ITAA 1936 and are not considered to give rise to contributions to the SMSF just from that one fact alone.

·        Taxpayer Alert 2012/7 was released on 20 November 2012 to warn SMSF trustees and advisors to exercise care to ensure any arrangements entered into by an SMSF to invest in property are the right investment for their SMSF and are properly implemented, particularly those involving LRBA or the use of a related unit trust. See also our earlier post: Beware! SMSF investing in Property

·        Issues and concerns of low rate loans and LRBA will be submitted to the review of borrowing. The ATO will be providing comments for the review when it commences.  This is likely to form part of the new Commonwealth Government's tax review although details are not yet to hand.

The ATO recently considered this in two private binding rulings (see 1012414213139 and 1012396819768). These rulings involved SMSFs that had 0% interest rate loans from related parties. In both the ATO concluded that the income derived was not non-arm’s length income which is positive news for those taxpayers. However, private rulings are not binding on the ATO and the full details are not always made public.

Take care and get a Ruling

Although limited recourse borrowing arrangements (LRBA) are becoming more common, care must be taken, especially with related party loans. Particular care should be taken in respect of non-arm’s length income given the tax consequences.

If an SMSF wants to engage in a related party borrowing transaction with favorable terms for the SMSF (ie, non-arm’s length terms) you must apply for a private ruling from the ATO and it is likely that such a ruling would only be applicable for 12 months.

It would not surprise us if in time s. 109 of the SIS Act (investment at arm's length) is amended to include related party loan transactions at market value.

Beware! SMSFs investing in property

From time to time the Tax Office issues “Taxpayer Alerts” intended to be an “early warning” of significant new and emerging higher risk tax and superannuation planning issues or arrangements.  This is published for SMSF trustees and their financial advisers “to exercise care” .

The latest Taxpayer Alert TA 2012/7 published 20 November 2012 relates to self managed superannuation funds (SMSFs) which acquire property in contravention of the superannuation laws.  You can find it in full here.  The ATO is particularly concerned about acquisitions involving limited recourse borrowing arrangements (LRBA) or the use of a related unit trust.

Incorrect structuring of such arrangements may lead to a range of significant consequences for the fund such as:

• Having to include the SMSF loan repayments in members’ assessable income;
• Members having to declare the income and associated deductions from the investment rather than by the SMSF;
• Rendering the SMSF non compliant for tax purposes, leading to the requirement that it include amounts of income from previous years in its assessable income (45% tax rate applied to its income and market value of its assets other than undeducted contributions measured at the start of the income year in which the fund becomes non-complying.  There may also be civil or criminal penalties for trustees);
• The unit trust might incur a capital gains tax liability in relation to the disposal of the property; and
• The Members and the SMSF may be required to include a capital gain in their assessable income on redemption of their units in the unit trust.

Structuring such property acquisitions by SMSFs within the rules is complex and requires great care and knowledge of the Superannuation laws and regulations.  We have done these transactions for clients who have specific knowledge of the property in question together with a clear idea of its likely future performance and who are prepared to very carefully negotiate and structure the requisite documents.  It’s certainly not for everybody.

We also note that residential real estate in Australia would need to rise around 8% from today to reach its all time high (in 2010) and we consider generally that now is not the time to consider such an acquisition within super, with the primary purpose of seeking capital gains.  The Australian equity market by comparison needs to rise by over 50% from today to reach its all time high (2007).  In all likelihood both asset classes will make new highs in the next decade but this comparison shows equity markets have more to gain than Australian residential real estate.  The comparison is different for commercial and industrial property.

We know you won’t find many financial advisers in Australia taking this line –there are many spruikers out there offering to SMSFs the prospect of property investments using LRBA or related unit trusts.  Be warned!