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If an SMSF member has funds available outside their SMSF, it is possible to lend that money to their super fund, at a zero (or low) interest rate, under a limited recourse borrowing arrangement (LRBA) but when is it the right strategy?
Of course, you need to have the right reasons for using such a strategy and you need to ensure it is implemented in a way that is acceptable to the Australian Taxation Office (ATO) and the Superannuation Industry Supervision Act (SIS).
Zero-interest loans have been a bit of a grey area for some time because, if structured incorrectly, they could breach Section 109 of the SIS Act and the arms-length provisions of the Income Tax Assessment Act.
According to S109 of the SIS Act, an SMSF trustee can't transact with their own fund unless the dealing is "at arms-length". On the surface, it looks like a loan from a member to their own SMSF would fail this "arms-length" test.
However, S109 also says that if the transaction is not made at arms-length, then it has to be one in which the terms are no more favorable to one party than to the other.
On this basis, if the member doesn't charge their SMSF interest on money lent, it is difficult to see how the terms are more favorable to the member than they are to the fund.
In fact, you could argue the terms of the loan are more favorable to the SMSF than they are to the lender. As such, a zero interest loan from a member under the limited recourse borrowing arrangements could stay within the boundaries of the SIS Act.
The Australian Taxation Office (ATO) made an Interpretative Decision around this issue back in 2010 in ATO ID 2010/162.
The specific issue that decision looked at was: "Does an SMSF trustee contravene Section 109 of the Superannuation Industry (Supervision) Act 1993 if it borrows money from a related party of the SMSF under a limited recourse borrowing arrangement on terms favorable to the SMSF?
The ATO's decision was a very straightforward "No." In its decision, the ATO said:
"The terms cannot be more favorable to the related party than would have been the case had the parties been dealing at arm's length, but there is no contravention of Section 109...if the terms are more favorable to the SMSF."
The Income Tax Assessment Act also talks about non-arms-length income. If income made by a super fund is determined to be non-arms-length, it could be taxed at 45%. However, the ATO has made recent private binding rulings that have not treated income from such loans as non-arms-length. However, private binding rulings cannot be relied upon as precedents.
So, if recommending this strategy, how can you ensure it is in line with the ATO decision?
The key is to make sure money lent by a member to their SMSF is at an interest rate that is lower than the rate that would be available for a similar loan from a commercial (or arms-length) lender. The ATO would also expect to see that the terms and conditions of the loan are, in all other ways, apart from the interest rate, made on an arms-length basis.
The paperwork surrounding the loan agreement between member and fund also needs to be airtight. The loan arrangement will need to be supported with thorough documentation and record-keeping. It's also essential that the money a member lends to their SMSF is used to purchase an asset that may produce income for the fund.
Apart from the interest rate charged, any loan made by a member to their SMSF should be on strictly commercial terms to ensure it is legal.
Building more equity in the SMSF
Another reason for a member to make a zero- or low-interest loan to their SMSF is so that the capital provided can be used to boost the fund's equity so it has a better chance of qualifying for a commercial loan from a third party. The combined amounts (from the member's loan and the commercial loan) can then be pooled to buy an income-producing asset for the fund.
For example, most commercially-available LRBAs require relatively low loan-to-valuation ratios. If a consumer borrows outside of super to purchase a residential property, they only need 5% equity to qualify for some loans. It is not unusual for SMSFs to be required to have 30% equity when borrowing for a residential property and more for a commercial property.
The downside of using a loan from a member to boost a fund's available equity is that it could be an indicator that the SMSF has insufficient funds to go into an LRBA anyway. It can be dangerous for many reasons, for a super fund to hold too much of its equity in one large and illiquid asset, like a commercial building.
Can a SMSF have two lenders?
In Superannuation Technical Sub-group meeting in September 2013, the question was asked: If an acquirable asset is financed by two lenders under an LRBA and one or both of those lenders are granted a charge over the acquirable asset, will this breach paragraph 67A(1)(f) of theSuperannuation Industry (Supervision) Act 1993 (SISA)?
Super funds are not allowed to borrow unless the exception of Section 67A and B of the SISA. To come within the exception in subsection 67A(1) of the SISA, a borrowing must be made under an arrangement which satisfies the specific criteria set out in that subsection. This includes paragraph 67A(1)(f).
At the June 2012 meeting of the NTLG Superannuation Technical Sub-Group, the Commissioner noted that the criteria in subsection 67A(1) of the SISA do not operate to restrict the number of borrowings that may be included in an arrangement. However, in relation to each borrowing that is a part of an arrangement, the rights of the lender (or any other person) must meet the conditions of paragraphs 67A(1)(d) and (e) of the SISA.
The ATO's response was that Paragraph 67A(1)(f) of the SISA will not be contravened merely because there are two borrowings that are part of an arrangement where one or both borrowings involve subjecting the acquirable asset to a charge that satisfies paragraph 67A(1)(d) of the SISA in relation to the particular borrowing that involves subjecting the acquirable asset to that charge.
For example assume a SMSF has "nil" balance or say $20, and then it is still possible for the fund to purchase a property by borrowing albeit from two lenders of which one is a related party. In other words, if the SMSF borrows without a charge from a related party to make up the full purchase price including borrowing costs and initial repair costs, the fund will not breach Section 67A(1)(f) only if the bank puts a charge over the property.
The borrowing from a bank can be at the required LVR, say 70% and from a related party to make up the required LVR to purchase an acquirable asset plus stamp duty and other related initial repair costs. The bank will take over the 1st mortgage over the property which is being acquired by the SMSF and the related party does may not have to take a 2nd mortgage over the property (which the bank may not allow anyway to protect their limited recourse). Internal loan documents sold by us contain this loan agreement, click here to learn more.
Loan may not count towards member contribution
The ATO has also tentatively confirmed that any nil-interest loan made to an SMSF by a member may not be considered to be a contribution to the fund by that member. The proviso is that the loan agreement must contain a "genuine intent" on behalf of the fund to repay the loan.
In other words, a member loan could be used as a way to get an amount of money into their SMSF that would be far greater than amounts currently allowed under concessional and non-concessional contribution caps.
However, statements made by the ATO about whether or not a nil-interest loan would be a contribution, were made at a National Tax Liaison Group meeting in 2012 and are, therefore, not binding. The jury is out on whether or not the ATO will issue a further decision in relation to the potential use of nil-interest loans as a way for members to get around their contribution caps. However, we recommend that as long mortgage stamp duty on related party borrowing is paid along with proper loan agreement, the money's lent to the SMSF may not be included as fund contribution.
Our position is to tread very carefully at this stage. This appears to be a loop hole in the LRBA arrangements that could enable SMSF members to "lend" their empty super funds large amounts of money without contribution cap consequences. We don't think the Federal Treasury will let this situation stand indefinitely. The loss of taxation revenue could be substantial.
The most prudent reason for a member to make a nil-interest loan to their fund is to put capital that they have outside the super environment inside their fund so it can generate income and capital growth in a tax-preferred environment. Such an arrangement is also cheaper for the fund than taking out a LRBA with a commercial lender at a 'market' interest rate.
The potential risks you'll need to weigh up are that legislative change could make the arrangement unworkable at some point down the track. Secondly, consider whether a non-super investment strategy would provide greater returns over the long-term for the member than making the zero-interest loan to their fund.
Other advantages
A low- or no-interest loan from a member may have other advantages over a commercial LRBA, including:
1. Lower upfront costs
2. No need for lender to review or amend trust deed
3. No need for personal guarantees from SMSF members to support the loan application
Depreciation claim for investment property
The Australian Taxation Office recognises that the value of capital assets gradually reduces over time as they approach the end of their effective life. These assets can be written off as a tax deduction - known as depreciation.
If the SMSF claims depreciation for the property purchased, this depreciation expense can create a tax shelter for rental income and contributions if there is no interest expense in Accumulation funds.
When your SMSF builds or purchases an already built investment property, it will have walls, roof and other plant. Each item, such as wall and floor tiles, wardrobes, kitchens, insulation batts inside the walls, cloth hoists etc have a different effective useful life. You can claim capital works deduction and decline in value of plant at different rates of depreciation (and by two different methods, written down value or price cost) depending on each items effective life
To claim depreciation for the funds investment property, you will need a quantity surveyor report to work out capital costs and depreciable items in your property. If the report identifies these items, depreciation can be claimed over the useful life of the asset. To learn more click here.
Remember to check your deed
Even if you think the strategy is acceptable under the SIS Act and in line with the ATO's Interpretative Decision, it is also essential to check your SMSF trust deed. Some deeds still don't permit any limited recourse borrowing arrangements and others may place restrictions on the types of investments a fund may hold.
The deed offered by us does enable LRBAs and is approved by all SMSF bank lenders and is in line with the ATO's thinking on loans from members that work in favor of the SMSF. To read what is in our deed, click here.
We also provide our customers with unlimited deed updates to ensure any future changes to the ATO's position on this matter can be accommodated. To change to our deed or learn more click here.
And be warned, the ATO has been known to change its mind. The best way to make sure any strategy you are considering is acceptable may be for the SMSF member to ask the ATO for a confirmation of its 2010 decision or even request a private binding ruling.
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