• The loan and the lender

    Is an SMSF allowed to borrow 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 be at 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 tax – arm’s length terms for Limited Recourse Borrowing Arrangements established by self managed superannuation funds

    Does the arrangement entered into by the SMSF trustee actually involve a borrowing?

    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.

    Can a related party borrow on a full recourse basis and on-lend the money to the SMSF under an LRBA at a higher rate of interest?

    Yes, 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:

    Does a drawdown from a credit facility give rise to a new borrowing?

    Yes. The Commissioner considers 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

    For real property held by the holding trust in an LRBA, can an SMSF trustee draw down under the arrangement to make capital improvements to the real property without contravening the super law?

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

    Yes. 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 entered into on or after 7 July 2010

    No. 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.

    Does an arrangement that permits capitalisation of interest or other borrowing charges satisfy the super laws?

    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.

    Arrangements entered into on or after 7 July 2010

    Yes. 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.

    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
      Last modified: 08 Feb 2016QC 20439