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  • The loan and the lender

    Genuine borrowing to acquire an asset

    It is essential that appropriate documentation clearly reflects that the trustee of an SMSF has made a genuine borrowing to acquire an asset, particularly where the monies provided to acquire the asset are from a related party. If there is not adequate documentation to prove the money provided by a related party was actually borrowed, the amount provided by the related party might be considered to be a contribution received by the fund. This could lead to significant tax consequences if it results in a contributions cap being exceeded.

    SMSF borrowing from a related party

    The law does not prohibit the lender from being a related party. However, we are likely to apply scrutiny to related-party LRBAs where the terms of the loan, taken together, and the ongoing operation of the loan, are not consistent with what an arm’s length lender dealing at arm’s length would accept in relation to the particular borrowing by the fund trustee.

    Additionally, 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.

    See also:

    • SMSFR 2010/1 Self-Managed Superannuation Funds: the application of subsection 66(1) of the Superannuation Industry (Supervision) Act 1993 to the acquisition of an asset by a self-managed superannuation fund from a related party

    Does a borrowing from a related party need to beat arm's-length?

    A trustee of an SMSF or its investment manager must ensure all investments are conducted on an arm's-length basis or, if the parties are not at arm's length, that the terms of the investment are no more favourable to the other party than they would be if the parties were dealing at arm's length.

    'Invest' is defined in subsection 10(1) of the SISA to mean applying assets in any way, or making a contract, for the purpose of gaining interest, income, profit or gain.

    When entering into the LRBA, the SMSF trustee is investing. Subsection 109(1) of the SISA imposes requirements with respect to transactions relevant to investments made by SMSF trustees. Borrowing money under the LRBA is a transaction entered into in the course of making an investment.

    This means that an SMSF trustee or investment manager cannot allow a related party lender to charge the fund more than an arm's-length rate of interest under the arrangement.

    The SMSF trustee must be able to demonstrate that the SMSF was not paying in excess of an arm's-length rate of interest to a related party. The calculation of a rate that represents an arm's length rate of interest needs to be based on reasonably objective and supportable data - for example, the rates charged by arm's length financial institutions for a similar borrowing.

    Paying a member or relative of a member an excessive rate of interest would also contravene the prohibition on SMSF trustees giving financial assistance to members or their relatives using the resources of the SMSF.

    See also:

    • SMSFR 2008/1 Self-Managed Superannuation Funds: giving financial assistance using the resources of a self-managed superannuation fund to a member or relative of a member that is prohibited for the purposes of paragraph 65(1)(b) of the Superannuation Industry (Supervision) Act 1993
    • ATO ID 2015/27 Superannuation: Income tax:  non arm’s length income – related party non-commercial limited recourse borrowing arrangement to acquire listed shares
    • ATO ID 2015/28 Superannuation: Income tax:  non arm’s length income – related party non-commercial limited recourse borrowing arrangement to acquire real property
    • PCG 2016/5 Income taxarm’s length terms for Limited Recourse Borrowing Arrangements established by self-managed superannuation funds

    Related parties on-lending money at a higher interest rate

    A related party can on-lend money to the SMSF under an LRBA at a higher rate of interest provided:

    • the limited recourse loan to the SMSF by the related party is appropriately documented
    • the SMSF is not charged higher than an arm's length rate of interest for borrowing
    • the arrangement under which the SMSF borrows from the related party otherwise meets the requirements of the super law.

    For arrangements entered into on or after 7 July 2010, the super law specifically prohibits the asset being acquired by the SMSF trustee under the arrangement from being used as security for the borrowing of the related party.

    See also:

    Loan repayments on behalf of the holding trust

    To meet the limited recourse borrowing requirements under the law your self-managed super fund must borrow the money directly from the lender to purchase the single acquirable asset. Your SMSF cannot make loan repayments for the single acquirable asset purchased by your holding trust.

    If your fund has entered into a borrowing arrangement where it has not directly borrowed the money this could result in a breach of section 67A.

    There could also be consequential breaches of the in-house asset rule and acquisition from a related party rule if the arrangement is not protected by the limited recourse borrowing arrangement exception.

    Drawdowns

    Drawdown from a credit facility are considered a new borrowing

    We consider each drawdown of funds, from a loan facility or similar arrangement, a separate borrowing, even if the facility or arrangement makes provision for redraws arising from earlier repayments. This view is more fully explained in paragraph 93 of SMSFR 2009/2.

    The terms of a single LRBA may allow multiple drawdowns by the investor. Each drawdown must be reviewed to determine whether the borrowing meets the requirements of the super law applying to the particular arrangement.

    If a drawdown is put to a purpose that does not meet the requirements of the super law – for example, the cash is put into a member's account - there is a contravention of the super law (specifically, subsection 67(1) of the SISA). Conversely, if the drawdown is put to a permitted purpose, such as the capitalisation of interest, then it does not result in a contravention of the super law.

    See also:

    • SMSFR 2009/2 Self-Managed Superannuation Funds: the meaning of 'borrow money' or 'maintain an existing borrowing of money' for the purposes of section 67 of the Superannuation Industry (Supervision) Act 1993

    Drawdowns to make capital improvements

    For real property held by the holding trust in an LRBA, an SMSF trustee may be able draw down under the arrangement – to make capital improvements to the real property – without contravening the super law depending on when the arrangements were entered into.

    Arrangements entered into on or after 7 July 2010

    Drawdowns for capital improvements are not allowed for arrangements entered into on or after 7 July 2010. The super law applying to these arrangements specifically prohibits borrowing to make improvements under subparagraph 67A(1)(a)(i) of the SISA.

    However, drawdowns to capitalise interest, maintain the asset and meet other costs of the arrangement continue to be allowed.

    Arrangements entered into on or after 24 September 2007 and before 7 July 2010

    Drawdowns for capital improvements are allowed for arrangements entered into between 24 September 2007 and 7 July 2010.

    When improvements materially alter the character of the original asset, they create a replacement asset for the purposes of subsection 67(4A) of the SISA.

    Under subsection 67(4A), the replacement asset is not limited to any particular type of asset but must be an asset that the SMSF trustee is not prohibited from acquiring. Assuming that the original property was an asset that the SMSF trustee was permitted to acquire, the improved property will be a permitted replacement asset.

    If the terms of a limited recourse borrowing arrangement allow the SMSF trustee to make drawdowns, then any drawdowns must be used for the acquisition of the original asset or its permitted replacement.

    Drawdowns to pay for capital improvements to the original asset meet this test, as do drawdowns to capitalise interest, maintain the asset and meet other costs of the arrangement. However, an SMSF trustee cannot make a drawdown to extract cash from the arrangement.

    SMSF trustees must not attach an existing fund asset to the real property or otherwise subject an existing fund asset to a charge under the arrangement.

    See also:

    Arrangements permitting capitalisation of interest or other borrowing charges

    Arrangements entered into on or after 7 July 2010

    The super law (specifically, subparagraph 67A(1)(a)(i) of the SISA) applying to these arrangements explicitly provides that, under a limited recourse borrowing arrangement, the SMSF trustee can apply borrowed money towards expenses incurred in connection with the borrowing.

    Example 1: Dividend income to reduce loan principal

    Under an arrangement that otherwise meets the requirements of the super law, any dividend income on the underlying share is applied first in reducing the loan principal amount. At one point in the year, the loan principal amount is increased by the capitalisation of the interest amount. This is permitted under subsection 67(4A) applying to arrangements entered into before 7 July 2010, because each amount so drawn down is applied as a cost of acquiring the underlying share. It is also permitted under section 67A applying to arrangements entered into on or after 7 July 2010.

    End of example

       

    Example 2: Dividend income paid to the investor

    Under an arrangement that otherwise meets the requirements of the super law, all dividend income on the underlying share is paid to the investor. The loan is drawn down annually and applied to pay the interest amount. This is permitted under subsection 67(4A) applying to arrangements entered into before 7 July 2010, because each amount so drawn down is applied as a cost of acquiring the underlying share. It is also permitted under section 67A applying to arrangements entered into on or after 7 July 2010.

    End of example

    Arrangements entered into on or after 24 September 2007 and before 7 July 2010

    Yes, provided:

    • the amounts capitalised are costs of the original borrowing (for example, interest or other charges directly incurred under the borrowing)
    • the original borrowing is applied to acquire the underlying asset
    • the lender's rights against the fund in the event of a default in repaying the capitalised amounts remain limited to rights relating to that asset (or a replacement asset).

    A further amount drawn down under the arrangement to pay interest on the outstanding loan amount or to pay other fees and charges associated with the borrowing is considered to be money applied for the purpose of acquiring the asset.

    Lenders recourse and charging the asset being acquired

    Granting the lender a right of recourse to the underlying asset at the same time that the trustee of an SMSF acquires the beneficial interest in the asset – is a necessary feature of an LRBA contemplated by the super law.

    Granting of such a right in these circumstances will not contravene the existing prohibition in the law against giving a charge over a fund asset, provided the arrangement complies with all the conditions of the super law.

    SMSF member personal guarantees to the lender in an LRBA

    Arrangements entered into on or after 7 July 2010

    An SMSF member can provide a personal guarantee to a lender in an LRBA provided the guarantors rights against the principal debtor (the SMSF trustee) are limited to rights relating to the asset being acquired under the arrangement.

    Under the super law applying to these arrangements, the recourse of the lender or any other person against the SMSF trustees in connection with, or as a result of, a default on the borrowing (either directly or indirectly) must be limited to rights relating to the asset that is being acquired under the arrangement.

    This means, for example, that for an arrangement to meet the requirements of the super law, any guarantor must not have general rights of indemnity against the principal debtor (the SMSF trustee) that might crystallise in the event of a call on the guarantee. However, the guarantor may have rights of subrogation of the lender's rights (that is, the right to exercise the lender's limited rights of recourse to the asset being acquired under the arrangement) that might crystallise in the event of a call on the guarantee.

    Arrangements entered into on or after 24 September 2007 and before 7 July 2010

    The recourse of the lender against the SMSF trustees in the event of a default on the borrowing must be limited to the asset that is being acquired under the arrangement. A third party may put up their own assets as a guarantee to provide additional security to the lender.

    It is not required that a third party guarantor waive their usual rights of indemnity against the principal debtor (the SMSF trustee) in the event of a call on the guarantee. However, SMSF trustees should carefully consider the risks to the assets of the SMSF (other than the asset being acquired under the LRBA) that an unlimited guarantee might represent. The rights of indemnity given in favour of a guarantor may be excluded or limited by the express terms of the guarantee.

    Personal guarantees and contributions to the SMSF

    If a guarantor makes a payment to the lender under an arrangement where they have foregone their usual rights of indemnity against the principal debtor (the SMSF trustee) in respect of the guarantee, this is a contribution to the SMSF if it satisfies a liability of the SMSF. This might happen, for example, if the guarantor paid the borrowing and the acquirable asset was transferred to the SMSF trustee under the arrangement.

    In contrast, there is no contribution if the SMSF trustee has exercised a right to walk away from the arrangement (and has lost the acquirable asset to the lender) and has no further liability, but the lender still exercises a right to call on the guarantee for a shortfall after disposal of the original asset.

    See also:

    Can a related party to the SMSF give a mortgage to the lender over an asset of the related party?

    Arrangements entered into on or after 7 July 2010

    A related party can give a mortgage to the lender over an asset of the related party provided the related party or any other person has no rights of recourse against the SMSF trustee in the event that the mortgage is exercised by the lender (for example, if the SMSF trustee defaults on the borrowing), other than rights relating to the asset being acquired under the arrangement.

    Arrangements entered into on or after 24 September 2007 and before 7 July 2010

    Under the super law the recourse of the lender against the SMSF trustees in the event of a default on the borrowing must be limited to the asset that is being acquired under the arrangement.

    However, a third party can mortgage one of their assets (in which the SMSF does not have an interest) to the lender to provide the lender with additional security.

    Can the asset being acquired be used as security other than in respect of the borrowing by the SMSF trustee?

    Arrangements entered into on or after 7 July 2010

    Assets acquired after 7 July 2010, cannot be used as security (other than for borrowing by the SMSF trustee).

    The super law (specifically, paragraph 67A(1)(f) of the SISA) applying to these arrangements prohibits any charge over the asset other than in respect of the borrowing by the SMSF trustee under the arrangement.

    Arrangements entered into on or after 24 September 2007 and before 7 July 2010

    SMSF trustees need to be careful that such a charge over the asset held in the holding trust does not contravene the law.

    For example, all of the SMSF trustee's dealings in respect of the arrangement must meet the arm's length requirements in section 109 of the SISA, no member or relative of a member can be financially assisted by the SMSF trustee using the resources of the SMSF and the maintenance of the fund must be in accordance with the sole purpose test.

    There may be limited circumstances where such a charge does not result in a contravention of the SISA, but for the reasons given above we would not encourage it.

    See also:

      Last modified: 10 Oct 2018QC 20439