By Bryce Figot and Daniel Butler
Comments by the ATO in the June NTLG Superannuation Technical Sub-group suggest that below market value interest rates do not constitute a contribution. This has caused much 'interest' (pun intended) in the SMSF community. This article explores what constraints still exist when setting the terms of a related party SMSF loan.
The exact comments
The ATO were posed the question:
A further question was posed:
(Naturally, the above are only extracts and are no substitute for reading the full comments, which are available on the ATO website.)
Firstly, remember that the NTLG Superannuation Technical Sub-group minutes are not binding on the ATO. They reflect the position at the date of release and that position may subsequently change.
Accordingly, the comments should be taken with a 'grain of salt'.
Arm's length requirements in the SISA
In ATO ID 2010/162, the ATO considered the question:
The ATO in turn respond:
Accordingly, it appears that the ATO only view the SISA arm's length requirements as contravened if the loan terms favour the lender. If the loan terms favour the SMSF, ATO ID 2010/162 suggests that there is no contravention of s 109.
Naturally, div 7A of the Income Tax Assessment Act 1936 (Cth) should be considered. If the lender is a company (or even a trust in certain circumstances), unless the loan meets strict criteria, it could be treated like a dividend. If div 7A were to be enlivened, the tax consequences could be significant.
Non-arm's length income provisions
On its face, the non-arm's length income of the Income Tax Assessment Act 1997 (Cth) do not apply. However, upon closer investigation, they are probably the key constraint to be considered when setting the terms of the loan.
A superannuation fund's non-arm's length income is taxed at the highest marginal tax rate, regardless of whether the fund is in pension mode. Income - both ordinary and statutory - can constitute non-arm's length income in a variety of ways. The key way in this context is if the following two limbs are both met:
- Limb A - the income is derived from a scheme the parties to which were not dealing with each other at arm's length in relation to the scheme.
- Limb B - the income is more than the amount that the fund might have been expected to derive if those parties had been dealing with each other at arm's length.
In light of the above, consider the following.
Errol's SMSF has $450,000 cash and wants to borrow $300,000 so that it can acquire a $750,000 residential property. Banks are offering Errol's SMSF an interest rate of 7%. However, by drawing down on his home loan, Errol personally can borrow at 5.9%.
Accordingly, Errol personally draws down $300,000 then on lends to his SMSF at 5.9%. The property acquired is then leased to an unrelated party for an arm's length amount. Assume that the arm's length amount of rent is 3% of the property's value (ie, rent of $22,500 pa).
This situation does not enliven the non-arm's length income provisions. This is because limb B is not met. Limb B is not met because the income (ie, the gross income of $22,500) is not greater than what the fund would have earned if the parties were dealing at arm's length (ie, $22,500).
However, a closer investigation is warranted.
Firstly, in the example above, there is an interest saving of $3,300 pa (ie, 1.1% x $300,000). If the parties were dealing at arm's length, the fund would not have this extra $3,300. Assume the $3,300 was placed in a term deposit earning 5.5% pa. The $3,300 will earn $181.50 (ie, $3,300 x 5.5%) of interest pa. Had the parties been dealing at arm's length, this extra $181.50 would not have arisen. Accordingly, this $181.50 amount might be sought by the ATO to be non-arm's length income. At first glance, most would dismiss this based on a de minimis approach. However, the $181.50 amount arises using reasonably modest figures. If the interest rate at which Errol lends is very low (eg, 1% or 2%) and the amount of the loan is very large (eg, $5 million), the non-arm's length income amount might become quite sizable.
Secondly, consider an SMSF where a related party lends 100% of the value of real estate. The loan might be $2 million. If the real estate is commercial it might yield rent of 8% (ie, $160,000) on an arm's length basis. The ATO may well say that no arm's length lender would lend $2 million to an SMSF on a 100% loan-to-value ratio and accordingly every dollar of rent is higher than it would be if the parties were dealing at arm's length. If such a view is correct, all of the $160,000 - plus any net capital gain arising from any subsequent sale of the real estate - would be non-arm's length income and taxed at the highest marginal tax rate (subject to any relevant deductions). Naturally, if the ATO adopted this view, the taxpayer could seek to counter it by adducing evidencing that the terms were the same that arm's length parties would adopt. However, if a bank is not willing to lend on such terms, the taxpayer could find itself in a difficult situation.
Advisers should ensure they cover off risks before recommending a low or no interest loan. It is best this is in a written record provided to the client to confirm the advice. Naturally, the implications of pt IVA and similar provisions should also be considered.
The ATO comments in the June NTLG Superannuation Technical Sub-group do suggest that related party loans will not give rise to excess contributions tax concerns. However, other concerns still remain, of which the non-arm's length income concern is key. Accordingly, when setting the terms of a related party loan, parties should be able to demonstrate that the income that the fund will generate is the same than if dealing at arm's length.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.