Overview
Who can lend to an SMSF to borrow?
There are no restrictions on who can lend money to the SMSF. The member can obtain a loan from a bank using other assets as security and then on-lend the money to the SMSF (commonly known as a back-to-back loan).
However, the loan must be on arm’s-length terms. A related party loan must satisfy Safe Harbour guidelines to avoid excess tax.
What are the potential issues with related party loans?
The Australian Taxation Office (ATO), in various publications going back to 2013, states related party SMSF loans can have the following issues, which means the fund is obtaining a benefit it would not otherwise enjoy if it was dealing with a third-party lender, such as a financial institution or a bank.
The ATO state that, with related party SMSF loans, the following factors may come into play:
- The interest rate may be zero or lower than the market rate
- Often the repayment terms are not commercial; for example, annual loan repayments versus monthly loan repayments with an arm’s-length lender
- Rather than periodic, regular payments of the principal sum, only a single lump sum repayment at the end of the loan term (which could be several years) is required
- 100% of the value of the assets to be acquired will be lent, rather than a lower loan to value ratio, given the nature of the assets to be acquired with borrowed Funds, namely shares and units in a unit trust (and given the limited recourse nature of the loans)
- No insistence by the lender on the giving of personal guarantees by the members of the Fund as security for the borrower’s performance under the loans.
The concern the ATO has is if individuals lend to their SMSF on terms favourable to the fund, they may be diverting money into the concessionally-taxed superannuation system that otherwise would not have occurred had the fund been dealing with a lender on arm’s length terms.
What is the penalty for non-commercial loans?
The income generated from an investment subject to a non-commercial LRBA can be taxed under what are called the Non-Arm’s Length Income (NALI) rules. These rules apply a penalty rate of tax of 45% on all net income from the asset subject to the non-commercial LRBA. Not only that, but the penalty tax can also apply to any future capital gain associated with the property.
Case Study 1
Beety and Joel have just sold their property inside the BJ Super Fund that was subject to a related party LRBA. The property was negatively geared within the SMSF. They did, however, manage to make a $60,000 capital gain on the sale of the property, which they are very happy with.
However, the loan terms were not commercial and the ATO determines that the NALI provisions will apply.
All net income from the property will be subject to tax at the rate of 45%. As there was no net income, there is no penalty tax on the property income.
However, the capital gain of $60,000 will be taxed at the penalty rate of 45%, rather than the normal fund rate of 10% for assets held greater than twelve months.
How can a related party loan be compliant?
Thankfully the ATO provides Safe Harbour Guidelines. If a related party loan stays within these confines, the ATO has stated the LRBA will not be subject to the NALI provisions. The parameters are as follows:
- The interest rate to be charged
- The term of the loan
- The loan to market value ratio
- The nature and frequency of repayments
- The security to be taken.
For property, the table below shows the Safe Harbour provisions:
Currently the RBA benchmark interest rate is 9.35% per annum. This rate resets every May, which then applies from 1 July the following financial year.
Conclusion
It is important clients understand the requirements for related party loans to an SMSF. Seeking professional advice before the decision to purchase an asset is crucial.
What does Neo Super provide?
We provide a fully integrated, flexible and comprehensive SMSF borrowing arrangement documentation service for property.
We also provide consultation services on a range of SMSF strategies.
For borrowing arrangement documentation for assets other than property, please contact our office.
Stay tuned Part 3, when we look at alternative ways to purchase property within an SMSF.
Further Information
If you have any questions about this Fact Sheet please contact Nicholas Ali, SMSF Head of Technical Services via email nicholasa@neo-super.com.au or mobile 0400 050 236.
