Answer to our Quiz: Instalment Warrant - How to magnify growth

 2 movie tickets won by two advisors

Our last quiz (see below) was on the issue related to instalment warrants and lending by SMSF to related parties. SMSF can now borrow as long as the arrangement is as described in Section 67 (4A) is met. However, can a trustee lend money to a SMSF or can a related party, like another SMSF, where the trustee is also a member lend money to the SMSF via an instalment warrant arrangement was specifically addressed in our quiz.
 
The question was not easy but reflected a real life situation. Two of our readers got the answer correct they are work as SMSF advisors, Mr David Burnes of Asset Accounting(QLD) Pty Ltd & Mr Mark Caldwell of  Poulton & Associates (Ph 02 4225 7779) got it right  drum roll for them  two movie tickets are being mailed to them.
 
The correct answer to our Instalment warrant Quiz is (5)

 
Reasoning:
 
As Fund A has the property and Fund B has the cash 

Fund A has the entire taxable component and Fund B has the Tax Free component. Hence to avoid any future death tax, advisor should attempt to increase Fund B and decrease Fund A.
 
The plan is simple

1) Fund B has to purchase the property at market price (Arms length transactions rule);
2) Fund B will pay to Fund A $600K cash

it will have only $300K cash left and it needs to pay minimum pension (4% of $900K) for the next two years, whilst the property is being developed, further it needs a further $300K cash to develop the property.
3) Fund B should borrow from Fund A as now Fund A is holding $300K in shares and $600K in cash.
 
Many readers did not pick this option as they thought Fund B is OK as via instalment warrant they can borrow from a related entity; however Fund A is not OK since Fund A cannot lend money to a related party.
 
Some readers choose option 4, but it is incorrect, because

1) if the property moves (Roll over) to Fund B from Fund A

2) the transaction will be for financing an existing asset and not a new asset , which means that it will not comply to Section 71(8) conditions, read below.
 
Lending by a fund to related parties is covered by two sections
 
1) Section 65 Lending to members of regulated superannuation fund prohibited (see full extract below (1))
 
2) Section 71 (1) In house asset rules (see part extract below  (2))
 
 
Sec 65 of the SIS Act applies to the prohibition relating to lending to fund members or relatives (see definition (3) below) of the member, however does not restrict lending to another fund hence, so this section does not apply.
 
Section 71(1) of the SIS Act applies to this Loan arrangement (Lending from Fund A to Fund B as trustees of the two funds are the same individuals).
 
Section 70B (see extract below  (4)) of the SIS Act clearly link the two funds as the trustees of the two funds are the same individuals. In other words, loan from Fund A to Fund B is to a "Part 8 associate" or primary entities of the two funds (individual trustees) are associated.
 
For purposes of Part 8 associate, each of the two trustees (John & Joan) are associates as they are the primary entity of both fund, whether or not they act in the capacity of trustees.
 
However, due to Section 71 (8) (see extract below (5)) if the lending by Fund A to Fund B is via an instalment warrant situation as per Section 67(4A), the asset becomes an inhouse asset if it is in existing asset.
 
Hence, any lending by Fund A to the bare trust for a new asset purchase (could be purchased from Fund B) via an instalment warrant arrangement (that is via a bare trust structure) which is related to Fund B will not be considered an as Inhouse asset of Fund A as long as the asset purchased is a new asset.
 
Since the above strategy is all NEW STUFF, we recommend that you initiate a private ruling from ATO before taking any action. Further, if are an advisor, who have clients who want to do big things, please ensure that your client's trust deed is rock solid and includes the basics of related unit trust structure via instalment structure.
 
All the other options will increase balance of Fund A, that is taxable component and since John and Joan are 61 years old and it will take two years to build, furhter there will be limited chance to collect enough cash to convert taxable component to tax free component once they are over 65 as they are retired (a condition for over 65's is that members must work to contribute to a fund)
 
Our intention of this quiz is to educate advisors and trustees and nudge them to think outside the square please note we sell trust deeds and not "toilet paper" and the quality of the deed is second to none in the market place.
 
If your supplier (or the solicitor who writes their deeds) cannot give you the correct answer to our Quiz, the question is: Are you buying a quality deed or toilet paper? Feel free to send our quiz to your deed supplier.
 
 
Extracts as described above
 
(1) Section 65 Lending to members of regulated superannuation fund prohibited
Prohibition
(1) A trustee or an investment manager of a regulated superannuation fund must not:
(a) lend money of the fund to:
 (i) a member of the fund; or
 (ii) a relative of a member of the fund; or
(b)give any other financial assistance using the resources of the fund to:
 (i) a member of the fund; or
 (ii)a relative of a member of the fund.
(2) Part 8 of SIS Act 71(1)  Meaning of in house asset Basic meaning

For the purposes of this Part, an in house asset of a superannuation fund is an asset of the fund that is a loan to, or an investment in, a related party of the fund, an investment in a related trust of the fund, or an asset of the fund subject to a lease or lease arrangement between a trustee of the fund and a related party of the fund, but does not include:
 
(3) relative, in relation to an individual, means the following:
(a)a parent, grandparent, brother, sister, uncle, aunt, nephew, niece, lineal descendant or adopted child of that individual or of his or her spouse;
(b)the spouse of that individual or of any other individual specified in paragraph (a).
 
(4) Section 70B  Part 8 associates of individuals
For the purposes of this Part, each of the following is a Part 8 associate of an individual (the primary entity), whether or not the primary entity is in the capacity of trustee:
(a)a relative of the primary entity;
(b)if the primary entity is a member of a superannuation fund with fewer than 5 members:
(i)each other member of the fund; and
(ii)if the fund is a single member self managed superannuation fund whose trustee is a company, each director of that company; and
 (iii)if the fund is a single member self managed superannuation fund whose trustees are individuals, those individuals;
 
(5) Section 71 (8) Meaning of in house asset
 
If, at a time:
(a) an asset (the investment asset) of a superannuation fund is an investment in a related trust of the fund; and

(b)the related trust is one described in paragraph 67(4A)(b) in connection with a borrowing, by the trustee of the fund, that is covered by subsection 67(4A); and
 (c)the only property of the related trust is the original asset or replacement described in that subsection;
the investment asset is an inhouse asset of the fund at the time only if the original asset or replacement described in subsection 67(4A) would be an inhouse asset of the fund if it were an asset of the fund at the time.
 
 

Quiz: Instalment Warrant  How to magnify growth

 

John is 61 years old is married to Joan also 61 years old, both are retired. They have been managing their Self Managed Super fund (Fund A) for last five years. They sold their own house in January 2008 for $1.2M and setup another fund (Fund B) in January 2008 to avoid adult children paying tax on growth of assets at the time of death and deposited undeducted 900K ($450K each) to this fund and commenced a pension. With the balance they purchased a decent villa in north coast.

John & Joan Fund A has $600K in it, all deductible contributions ($300K shares & $300K property  land) the fund was converted to pension phase on 1^st July 2007.

They want to develop land of Fund A which has been recently rezoned as commercial shopping; however at the moment this land is not generating any income. There is not enough money in Fund A to develop this land. They will need another $600K to develop and build 5 shops which will generate $150K rent on total investment of $900K ($300K land + $600K developing cost).

John & Joan think that developing this land is a good investment, since tenants are ready to sign long term leases with every year rental increase in line with CPI, along with capital growth. But it will take two years to build and they need at least minimum 4% pension to live as they are retired.

Which legal option would you recommend to John and Joan for best result for them and their adult children?

1)      John and Joan should not develop the land as Fund A does not have enough cash to develop the property and should sell the land for $600K market price;

2)      Use Fund B's cash to develop land owned by Fund A as tenants in common;

3)      Fund A should borrow from Fund B via an instalment warrant;

4)      Fund A should sell the property to Fund B for market price of $600K. The property can move to Fund B as an instalment warrant. Then fund B can use its $600K of its $900K to develop the property, pay interest to Fund A and pay pension to the two pensioners for the next two years, Fund A can sell shares to pay pensions ;.

5)      Fund A should sell the property to Fund B for market price of $600K for cash. It will have only $300K cash left, Fund A should lend (via an instalment warrant) to Fund B, $600K cash to complete the purchase so that Fund B can develop the land for $600K and pay a pension to the two pensioners for the next two years, Fund A can sell shares to pay pensions.

6)      The above options (4) and (5) cannot be used as any related party (including a SMSF) cannot lend money as an instalment warrant to a SMSF.

7)       Commute pension of Fund B, rollover the cash in Fund A, then commence a pension and develop the land for rental income. Ignoring any tax adult children may have to pay on growth of rental property.

Please answer to quiz@ucservices.com.au with your 2 line reason for your answer. First 5 correct winners will be mailed 2 movie tickets. Please answer with your mailing address before 10th June.

If you are an advisor, please let us know if you want us to mention your name to our readers in our next newsletter, this email goes to over 9000 people - many are trustees  mentioning your name and phone number may mean more business for you.