Borrowing and compliance: if one goes wrong for an SMSF, then the other will too. The result? Two hefty bills which could plunge the fund "into the red": one bill from the lender requiring funds to be repaid on default, the other bill from the ATO.
For an SMSF with borrowings under an instalment warrant arrangement, compliance with superannuation law becomes paramount. In the worst case, non compliance would cause — at more or less the same time:
- a requirement for the loan to be repaid to the lender; plus
- the ATO taxing the fund's income for the current year at the highest marginal rate; and
- the ATO charging tax equal to 45% of the fund's assets as though no money was owed under the loan.
(Note that borrowing in SMSFs — and other super funds — is generally prohibited, here Certain exceptions were introduced in 2007.
In this article, we:
- look at a case study that highlights the importance of compliance for funds that borrow — especially funds with members who reside outside Australia; and
- more generally consider non-compliance issues for SMSFs that borrow.
Case study: Betty and George, and why compliance is essential for a leveraged SMSF
The trustees of an SMSF wish to purchase a property (known locally as 'the Q1 Building') and approach the manager at the local Sunshine Bank to see if the bank will fund the purchase under an instalment warrant arrangement.
The trustees, Betty and George, are also the SMSF's only members. They tell the manager that they have $300,000 cash in their SMSF, which they rolled-out from their industry fund specifically to buy some property.
Conveniently, the Sunshine Bank has a policy of 75% LVR on property-related lending under instalment warrant arrangements, and Betty and George are pretty sure they can seal the deal on the Q1 Building for no more than $1,000,000.
Sure enough, the transaction proceeds:
- Betty and George register a company, B&G Custodian Pty Ltd to purchase the Q1 Building as custodian for their SMSF.
- Sunshine Bank lends $750,000 to Betty and George in their joint capacity as trustees of the SMSF.
- Sunshine Bank takes a registered land mortgage from B&G Custodian Pty Ltd over the Q1 Building.
For a while things go very well. Rent on the Q1 Building, and some employer contributions to Betty and George's SMSF, cover the principal and interest repayments.
Then Betty gets a job in Dubai so Betty and George go to Dubai to live and work as expats.
The credit crisis
The international credit crisis then hits. Betty is doing insolvency work at a chartered accounting firm in Dubai so is earning plenty and keeping busy. So while the crisis hits the value of the Q1 Building reasonably hard, the rent and some super contributions still cover the loan repayments.
However, neither Betty, George nor their accountant are that familiar with SMSF residency rules.
The ATO's response
After three years in Dubai the ATO assesses their SMSF in the 2008/2009 tax year as a non-complying fund for failing to meet the residency requirements.
Normally, the ATO has some flexibility to determine whether an SMSF is complying. However, if an SMSF does not satisfy the residency rules, then under the SIS Act the SMSF is automatically non-complying. The ATO does not have the opportunity to determine whether the SMSF is complying or non-complying.
In the case of all other instances of an SMSF's non-compliance, the ATO does have a discretion to consider surrounding circumstances before it determines whether the SMSF is complying or non-complying.
The amount of tax assessable is punishing. If an SMSF becomes non-complying, then the trustees are taxed:
- at 45% on the SMSF's "assets less undeducted contributions". So the liability is assessed without reference to any liabilities which appear on the SMSF's balance sheet — that is, the ATO looks only at the value of the assets. (The relevant phrase in the legislation is "net previous income in respect of previous years of income". The assessment is made in the year the SMSF becomes non-complying.1)
- The SMSF is then also subject to tax at 45% on net income for the year in which the SMSF becomes non-complying (and all later years, for as long as it remains non-complying).
The lender's response
Becoming a non-complying fund is also a default under the loan agreement with Sunshine Bank, which then demands Betty and George immediately repay the loan.
Set out in the appendix is the balance sheet for Betty and George's SMSF which — as a consequence of the SMSF becoming non-complying — now has a negative net asset position.
Instalment warrant arrangement borrowings and the general risks to compliance
In brief: the structure of "instalment warrant arrangements"
The law now allows SMSFs to borrow through what is known as an "instalment warrant arrangement" — even though the required structure does not fit the description of an instalment warrant as commonly understood.
In very brief terms, these instalment warrant arrangements (which can more accurately be described as "limited recourse loan arrangements") permit borrowing if:
- Loan and security: There is a loan made to the SMSF, supported by a form of security (for example, a mortgage or charge);
- New assets only: The money borrowed is applied solely for the acquisition of an asset;
- Asset a permissible investment: The asset is one that the SMSF is not otherwise prohibited by superannuation law (or any other law) from acquiring;
- Custodian must hold asset: The asset is held on trust for the SMSF under an appropriate custody arrangement. The relevant custodian must then provide the mortgage or charge to the lender;
- SMSF may obtain title once loan repaid: The SMSF has the right (but not the obligation) to acquire legal ownership of the asset after making the final instalment payment under the instalment warrant arrangement (that is, under the loan agreement); and
- Lender has limited recourse: The rights of the lender under the instalment warrant arrangement must be of a limited recourse nature — that is, if the borrower defaults, then the lender's rights to recover its money are limited to exercising its right in respect of only the asset purchased with the borrowed money.
A Summary of Compliance Imperatives
There are two categories of compliance imperatives:
- Amplified, or specific, compliance risks: These are compliance risks that:
- are amplified by the presence of debt, or
- which arise only because the instalment warrant arrangement exists; and
- Common compliance risks: These are compliance risks which exist regardless of whether an SMSF has debt.
Amplified, or specific, compliance risks
The importance of some compliance requirements are amplified if the SMSF carries debt:
- Residency rules— as the case study about Betty and George, above, shows, the issue of residency is paramount because of the immediate consequences of non-compliance. In brief, the residency requirements are that for a SMSF to qualify for tax concessional status it must be an "Australian superannuation fund".2 This requires it to:
- be established in Australia, or have an asset situated in Australia;3
- have its central management and control in Australia;4 and
- meet the active members requirement.5
- Investment strategy: the SIS Act requires the trustees to 'formulate and give effect to' an investment strategy for the fund6. The existence of debt:
- brings the investment strategy into sharp relief: for example, does the investment strategy take into account debt on the balance sheet and the increased exposure to a particular class of assets?; and
- requires a constant re-evaluation of the investment strategy in order that it is adjusted in response to any unexpectedly good, or poor, performance.
- Asset "not otherwise prohibited": The ability to borrow in SMSFs has made some trustees giddy with excitement at the prospect of purchasing assets not usually permitted in an SMSF. But the exception to the borrowing prohibition is precise and clear. It is a condition of the exception that the asset purchased:
Additional compliance risks arise out of the conditions (or compliance requirements) which apply to SMSFs only if they have instalment warrant arrangements.
- Structural requirements: the structural requirements described above must be put in place and maintained throughout the instalment warrant arrangement. Consequently, specific compliance requirements include that:
- the SMSF needs to appoint a custodian under a suitable custody arrangement;
- the custodian needs to hold legal title to the relevant asset(s); and
- the form of security (mortgage or charge) must be of a limited recourse nature.
- Loan terms: the terms of the loan must comply with super law: For instance, concerning interest payable under the loan:
- Interest payable at a greater than commercial rate (effectively, funnelling funds out of the SMSF) presents problems:
- It may, arguably, be a breach of the section 52 sole purpose test: using SMSF assets to divert wealth out of the SMSF for purposes other than retirement;
- It may, arguably, be a breach of the release conditions (Schedule 1 to the regulations made under the SIS Act); and
- It may, arguably, be a breach of the section 65 lending (financial assistance) to members and relatives;
- Interest payable at a less than commercial rate (or 0%, but still with obligation to repay) may mean the loan is characterised as a contribution to the fund. This may be taxed at 15%, and may create a liability for "excess non-concessional contributions tax" under Division 292 of the ITAA97; and
- Capitalising interest may offend the requirement that "the money borrowed is or has been applied for the acquisition of an asset".7 The ATO has stated that arrangements in respect of capitalising interest will continue to satisfy the requirements of section 67(4A) in limited circumstances, namely if:
- the amounts capitalised are costs of the original borrowing;
- the original borrowing is applied to acquire the underlying asset; and
- the lender's rights against the SMSF in the event of a default in repaying the capitalised amounts remain limited to rights relating to that asset (or replacement asset).
Common compliance risks
The following compliance requirements are common to all SMSFs but are worth revisiting regularly — particularly when an instalment warrant arrangement is being considered.
- Related party transaction rules—Section 66 of the SIS Act prohibits acquisitions of certain assets from members of the SMSF. For example acquiring property, which is not business real property, from a related party.
- In-house asset rules— Assets acquired (or any replacement) under an instalment warrant arrangement must not offend the in-house asset rules in Part 8 of the SIS Act (sections 69-85).
- Arm's length dealings—Section 109 of the SIS Act requires an SMSF's investments (including dealings in relation to all aspects of an instalment warrant arrangement) to be either at arms length or made on an arms length basis. Primarily, in the context of instalment warrant arrangements, these arm's length issues may arise in relation to the interest rate agreed between the SMSF and the lender.
- Prudence and standard of care—In addition to the requirements of section 52 of the SIS Act concerning a SMSF's investment strategy (discussed above), section 52 also requires other standards of behaviour in relation to trustees and directors of corporate trustees, such as section 52(2)(b):
to exercise, in relation to all matters affecting the entity, the same degree of care, skill and diligence as an ordinary prudent person would exercise in dealing with property of another for whom the person felt morally bound to provide
Appendix: "Into the red: non-compliance and leveraged SMSFs"
Suddenly, Betty and George's SMSF is looking very sick indeed:
|Assessment of current year income
|Current year income
|(Rent less expenses)
|Tax on current year income
|$56,000 x 45% (non-complying rate of tax)
|Assessment of 'net previous income'
|'Net previous income'
|(Assets less undeducted contributions: assuming the Q1 Building valued at $800,000)
|Tax on net previous income
|$800,000 x 45% x (non-complying rate of tax)
|Current year income
|The Q1 Building
|Borrowings with Sunshine Bank
|Net Assets (Liabilities)
1 Section 288A(1) of the Income Tax Assessment Act 1936 (ITAA36)
2 Section 295-95(2) of the ITAA97
3 Section 295-95(2)(a) of the ITAA97
4 Section 295-95(2)(b) of the ITAA97
5 Section 295-95(2)(c) of the ITAA97
6 Section 52(2)(f)
7 Section 67(4A)(a) of the SIS Act