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Rules for SMSFs which lend money (NOT borrow money)

Have you, or your clients, lent money from a self-managed super fund (SMSF)? Or thinking of doing so? There are rules about lending arrangements which an SMSF Trustee can enter into on behalf of the SMSF.

Here are the key points

Melissa Ramov, Maddocks Lawyers

Overview

The key message is that SMSFs cannot lend money or provide direct or indirect financial assistance from the fund to a member, or a member's relative (e.g. an SMSF cannot guarantee a personal loan for a member).

SMSFs can lend to parties that are unrelated to members e.g. a friend of a member - but it must comply with the relevant rules. SMSFs should not lend money, or pursue investment strategies, which are not in the SMSF's best interests.

Lending to members and relatives - the prohibition

Trustees of SMSFs cannot lend money to members of the SMSF or their relatives.1

The ATO has stated that the following actions, amongst others, are regarded as lending to related parties, and are therefore prohibited:

  • Gifting an SMSF asset to a member or their relative;
  • Selling an asset for less than market value to a member or their relative; or
  • Purchasing an asset for greater than market value to a member or their relative.2

Trustees can lend to other parties but the loan terms must be on arm's length.

Lending through an unrelated trust

The ATO says that trustees of SMSF's need to be wary of investing funds (ie lending) into an unrelated trust which then on-lends the funds to a member of the SMSF or a relative of the member.

This form of arrangement attempts to circumvent the prohibition on SMSF trustees lending money to a member or relative of a member and may be regarded by the ATO as a breach of super laws.3

Additionally, one must remember that lending money is simply another way to invest the SMSF's money - so all other trustee duties apply. Here are some things we recommend you take into account if you, or your clients, are considering lending from an SMSF.

What about lending to related parties (other than a member or relative)?

Generally, an SMSF can make loans to related parties other than a member or relative, but the loan is regarded as an 'in-house asset'. This means that there are also strict rules in relation to these loans - including that the value of these loans, which constitute an investment, cannot comprise more than 5% of the value of the SMSF's assets.

The in-house asset rules in Part 8 of the Superannuation Industry (Supervision) Act 1993 also contain provisions which address arrangements designed to circumvent the rules, and specific anti-avoidance provisions in relation to schemes with the intent of artificially reducing the market ratio of in-house assets.

The investment strategy of the SMSF

The SMSF needs to have an investment strategy that includes the ability to lend. Trustees must to be careful when making investments on behalf of the SMSF to ensure that those investments comply with the SMSF's strategy, and any loan is not on terms which are likely to place the members' benefits at risk.

Lending is an authorised investment under the Cleardocs SMSF Trust Deed - see the 'Authorised Investments' clause of the deed.

So, what sorts of loans by the SMSF are allowed?

The ATO does not give a lot of guidance about what sort of loans it considers that SMSF trustees can make. However, the loan must be in the best interests of members (and not place the member's benefits at risk) and comply with the fund's investment strategy. The loan should also be conducted on a commercial, arm's length basis, in accordance with section 109 of the SIS Act.

Striking the right terms for the loan, particularly where related parties are involved, is essential. For example:

  • if the interest rate charged to a related party is too low (and favours the borrower), or the terms of the loan do not reserve normal rights of the lender to demand repayment, then the loan arrangement will likely offend section 109 of the SIS Act, and may also offend the sole purpose test which SMSFs must always satisfy;
  • if the interest rate charged to the related party is too high (and favours the SMSF as lender), then the loan arrangement may result in the SMSF earning 'non-arm's length income' for tax purposes, losing concessional tax treatment on that income which is then taxed at the highest marginal rate.

If an SMSF does lend money, on what terms should it do so?

You should be judicious and careful when lending from the SMSF. You should seek legal advice before an SMSF Trustee lends. Generally, trustees should do the following things if they do decide to lend:

  • write up the loan agreement and have it signed by all parties involved;
  • make sure that the loan agreement specifies all the terms of the loan, for example:

    • what the security for the loan is;
    • the repayment period;
    • when repayments will be paid and the amount of those repayments;
    • whether all repayments will be of principal and interest, or whether there will be some interest only period;
    • the interest rate;
    • make sure the interest and repayments are received by the SMSF in accordance with the loan agreement; and
    • take appropriate action (which may include legal action) to protect the SMSF's investment if the loan agreement is not followed;
  • make sure that all the security documents are properly prepared;
  • have all parties correctly execute the documents and take possession of their own originals; and
  • effect security registrations (such as a mortgage or general security agreement) as are necessary to protect the SMSF as lender.

Flow-Chart of SMSF Lending

Here's a flow-chart - which in very general terms - describes the process for lending money from an SMSF:

Does the SMSF have an investment strategy, or one that includes lending money?
Yes No
Proceed to next step Develop an investment strategy, which includes the capacity of the SMSF to lend
Does the SMSF trust deed allow the trust deed to lend money?
Yes No
Proceed to next step Amend the trust deed so the SMSF has the power to lend money
Is the SMSF allowed to loan moneys to the proposed borrower?
Yes No
Proceed to next step If the borrower is a member or relative of the SMSF, then section 65 of the SIS Act prohibits lending to them
Is the permitted borrower a 'related party' of the SMSF?
Yes No
Then the in-house asset rules under the SIS Act apply. Only 5% of an SMSF's assets may be represented by in-house assets. The loan terms then need to be settled on commercial terms so that the investment made by the SMSF in making the loan meets the requirements of the Fund and superannuation law.
Proceed to next step Proceed to next step

Consider the 'reasonable' loan terms:

  • The loan terms need to be standard terms for the sort of loan that it is; and
  • The trustees of the SMSF must invest with other parties on arm's length terms (see Section 109 of the SIS Act)
Proceed to next step

Document the loan agreement, and include the following terms:

  • What the security for the loan is;
  • The repayment period;
  • When repayments will be paid and the amount of those repayments; and
  • The interest rate.
Proceed to next step

Document any security for the loan:

  • If the borrower is a corporate borrower then an appropriate security interest should be registered on the PPSR;
  • Guarantees by persons or entities in support of the borrower's obligations; and
  • Mortgages as security for performance of the loan, or a guarantee, and suitable registrations on title.

More information from Maddocks

For more information, contact Maddocks on (03) 9258 3555 and ask to speak to a member of the Commercial team.

More Cleardocs information on related topics

You can read earlier ClearLaw articles on a range of topics, such as:

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Andrew Wright
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Andrew is a Partner in the Maddocks Tax & Revenue team.

Andrew provides advice on:

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Prior to joining Maddocks, Andrew was a tax consultant at a Big 4 Chartered Accounting Firm.