SMSF borrowing: tax risk for any payments under a guarantee - draft income tax ruling

Some banks lending to SMSF trustee(s) under instalment warrant borrowing arrangements are requiring a guarantee as part of the loan security. In a recent draft ruling, the Tax Commissioner has suggested that any payment under those guarantees will be taxable as a 'contribution' to the SMSF.

Certain strategies can help reduce the amount of any tax payable if the borrower defaults and the guarantee is enforced.

 

The law about SMSF Borrowing has changed since this article was written. The article on this page has not been updated. You can link to the changes from the short note at the top of this page.

Background: SMSF trustee(s) can now borrow to invest

In September 2007, the superannuation law was amended to allow SMSF trustee(s) to make certain investments in their SMSFs using borrowed money. The relevant borrowing arrangements are known as 'instalment warrant arrangements'. You can read recent ClearLaw articles on SMSFs and instalment warrant arrangements, including an interactive graphic overview about how instalment warrants work, here

The article below discusses the ATO's view that tax may be payable on any payment made under a guarantee provided to secure an instalment warrant loan.

Why are guarantees an issue for SMSF borrowing?

Guarantees are an issue for SMSF borrowing because the law requires that the loan be a 'limited recourse loan' — that is, the lender's right to recover money owing under the loan must be limited. Specifically, the law limits the lender's right as follows:

the rights of the lender against the regulated superannuation fund trustee for default on the borrowing, or on the sum of the borrowing and charges related to the borrowing, are limited to rights relating to the original asset or the replacement.1

As the lender's rights 'against' the SMSF trustee(s) are limited to the asset purchased with the loan money, any guarantee the lender requires must be provided by someone other than the SMSF trustee(s).

Are bank's requiring guarantees for SMSF borrowing?

Some institutions lending to SMSF trustee(s) under instalment warrant arrangements are requiring a guarantee for the repayment of the borrowed amount be provided. To comply with the law (above), the guarantee is provided by someone other than the SMSF's trustee(s).

In this situation, if the SMSF trustee(s) default on the loan repayments, then the lender can claim the amount of the default under the guarantee.

What is the ATO's view?

In a recent draft ruling, the Commissioner suggests that in certain circumstances a guarantee under an instalment warrant arrangement could be a 'contribution' to the superannuation fund in which case it would be taxable.

The draft ruling TR 2009/D3 is available here.

When is a payment a 'contribution'?

The draft ruling explains the Commissioner's views of the meaning of the word 'contribution' as it is used in relation to superannuation funds, approved deposit funds or retirement savings accounts. (By the way, although the word 'Contribution' is not defined in either the Income Tax Assessment Act 1997 (ITAA97), or the SISA, there is a limited definition in regulation 1.03 of the Superannuation Industry (Supervision) Regulations 1994 (SISR).)

The Commissioner's view is that an amount will be a 'contribution' to a superannuation fund if it increases the capital or property of that fund that is available to derive real benefits on behalf of members. In the ruling, the Commissioner states that a contribution can be:

  • cash;
  • a money equivalent — including a money order, an electronic funds transfer, a bank cheque, a personal cheque or a similar negotiable instrument; or
  • made by transferring an asset to a superannuation provider — for example, either legal or beneficial ownership of property passes from the contributor to the SMSF trustee(s) on trust for the SMSF.

Why is a payment under a guarantee a possible contribution?

If an SMSF which does not have a sufficient funds to meet its loan repayments defaults on a payment to a lender, then the lender may go beyond the assets of the fund and call on the guarantor to pay the outstanding amount. In these circumstances, the guarantor's payment is taken to have increased the capital of the fund. Therefore, the guarantor's payment is a contribution.

  • If the guarantor has no right of indemnity, then the guarantor's payment under the guarantee becomes a contribution as soon as it is made; but
  • If the guarantor has a right of indemnity, then the guarantor's payment under the guarantee becomes a contribution only if both a payment is made under the guarantee and the guarantor then forgives its right to be indemnified for that payment.

How much tax is payable on a contribution to an SMSF?

The rate of tax assessable on a contribution to an SMSF depends on:

  • the total amount of contributions made to the SMSF in the relevant tax year; and
  • whether that amount exceeds certain 'caps' set by the law.

For the 2009-2010 tax year, the contributions caps and tax rates are as shown in the table:

Total amount of contribution Tax rate
Concessional contributions Up to $25,000 15%
Non-concessional contributions $25,001 to $150,000 31.5%
Excess non-concessional contributions More than $150,000 46.5%

How can SMSF trustee(s) help reduce the tax risk?

Can the guarantor take a right of indemnity from the fund?

No, a guarantor cannot take a right of indemnity from the fund because if it does so, then the guarantor's rights extend beyond the asset purchased under the instalment warrant arrangement — which would breach the 'limited recourse' requirement of the law.

What can be done?

SMSF trustee(s) can help reduce the risk as follows:

  • Choose your bank The simplest answer is to borrow only from institutions which do not require personal guarantees.
  • Limit the indemnity The trustee and guarantor can agree to limit the guarantor's right of indemnity to the asset purchased under the arrangement.
  • Conservative Loan to Value Ratios As the risk of the payment under the guarantee being taxed as a contribution arises only if the guarantee payment is made, the risk of the tax can be reduced by ensuring that the amount of the loan is much less than the value of the asset — which reduces the likelihood that the payment will be required. No breach of the contributions caps will take place until the guarantor makes a payment under. If conservative LVRs are in place then the risk of having to pay under the guarantee, and of having a deemed contribution, is greatly reduced.
  • Plan any guarantee payments If payment is required under a personal guarantee, then it should be properly structured (in light of the information in the table above) so as to reduce contributions tax.

Comments to the ATO

Comment on the draft ruling was due to the Commissioner by 17 July 2009. The ruling will remain in draft form until the Commissioner considers public comment and issues a final ruling.

Earlier ClearLaw articles on instalment warrants

Any questions?

For questions or more information about the above article, please call Maddocks in Melbourne (03 9288 0555) and ask for a member of the Maddocks Tax and Revenue Team or Superannuation Team.

More Cleardocs information on instalment warrants

Read about the 2 Cleardocs instalment warrant document packages

Order a Cleardocs instalment warrant document package:

Download a checklist of the information you need to order a Cleardocs instalment warrant document package:

1Section 67(4A)(d) of the Superannuation Industry (Supervision) Act 1993 (SISA).