The ATO has issued two documents in April about SMSF's borrowing through Instalment Warrants:
- a 'Question and Answer' document; and
- a Taxpayer alert.
Here we consider each of them.
The ATO speaks in Qs and As
The most interesting aspect of this publication about instalment warrants and SMSFs (which you can view here) is the fact that it was issued at all — which shows that the ATO has begun to accept that it can merely regulate SMSF borrowings, rather than prevent them. (This article discusses only self managed superannuation funds (SMSFs))
The Government, and Regulatory Disconnect
Since the laws allowing SMSFs to borrow were introduced towards the end of 2007, there has been a clear disconnect between the apparent views of:
- the former Parliament and Treasury, which were responsible for framing and enacting the legislation, and
- the ATO which is the regulator of SMSFs.
Parliament and Treasury took the view that limited recourse lending (or instalment warrant arrangements) was a necessary part of the superannuation investment landscape.
However it was always going to be the ATO which had to prescribe the limits for SMSFs. All this occurred in the context of the ATO's carefully planned — until then — transition, over several years:
- from an education-based approach,
- to a more interventionist approach, grounded in active monitoring and auditing.
By issuing this publication, the ATO has signalled that, at this stage, it can do little to prevent SMSFs from borrowing. Instead, it must focus on properly regulating those borrowings.
The ATO's comments and concerns
The more important aspects of the ATO's approach are as follows:
- It will adopt a pragmatic approach as to whether, at the end of the instalment warrant arrangements, there is a prohibited related party acquisition: We have examined this question in more detail in a separate ClearLaw article which you can view here;
- The custody trust which holds the underlying asset cannot be a unit trust: In the ATO's view, a unit trust imposes unnecessary complication and a layer of legal obligations which appear contrary to apparent requirement in the borrowing rules for a bare trust;
- The interest rate must be at a commercial rate: Although the SMSF and the lender can decide on the rate of interest, if the rate of interest is below market value, then the ATO may view the loan as more properly being a contribution to the fund (which would mean it was subject to contribution limits and tax);
- The governing rules (the deed) must permit the borrowing: The ATO will check whether the SMSF's deed allows the trustee to borrow. The deed must do that before instalment warrant arrangements are entered into. You can update the fund's deed (to specifically allow borrowing through an instalment warrant) by using the SMSF deed update service. It costs $99 and takes about 20 minutes online; and
- The instalment warrant arrangement must accord with the SMSF's investment strategy: The ATO will also be looking to ensure that the borrowing and purchase of the underlying asset are made in accordance with the SMSF's investment strategy.
The ATO's Taxpayer Alert 2008/5: Certain borrowings by SMSFs
Additionally, in its Taxpayer Alert 2008/5 (which you can view here), the ATO identified further areas of concern about SMSFs borrowing through Instalment Warrants. The concerns, and Maddocks' view on how to address them, are briefly summarised below:
- Money advanced by a member or related party at less than commercial rates of interest: As set out above, the ATO's view is that borrowings in these circumstances are likely to be considered as contributions. Accordingly, trustees and members need to make sure that all such loans are at commercial rates of interest;
- Money advanced by a member or related party at greater than commercial interests: The ATO's view is that this could result in:
- a breach of the sole purpose test; or
- a breach of the prohibition on funds providing financial assistance to members.
- Capitalising interest: The ATO's concern is that capitalising interest means that the money borrowed has not been applied for the acquisition of an asset, and therefore in breach of the new borrowing rules. Consequently, loan agreements should not have the effect of capitalising interest which is overdue. Instead, they should apply penalty interest; and
- Personal guarantees being provided by individuals in support of the SMSF's borrowing: The ATO's concern is that if the guarantor pays out an amount to the lender, then:
- the guarantor will have an implied right of recourse against the SMSF; and
- the right would not be limited to the asset purchased with the borrowings. This puts other assets of the SMSF at risk — which would be in breach of the new borrowing rules.
The likely solution to this problem is for the guarantor, when entering into the guarantee, to expressly disclaim any such implied right against the SMSF.
If you have any questions in relation to this article, or trusts, superannuation or tax generally, please call Maddocks in Melbourne on (03) 9288 055 or in Sydney on (02) 8223 4100 and ask for a member of the Maddocks Commercial Team.