Loan and lender compliance issues

Genuine borrowing to acquire an asset

It is essential that appropriate documentation clearly reflects that the trustee of an SMSF has made a genuine borrowing to acquire an asset, particularly where the monies provided to acquire the asset are from a related party.

If there is not adequate documentation to prove the money provided by a related party was actually borrowed, the amount provided by the related party might be considered to be a contribution received by the fund. This could lead to significant tax consequences if it results in a contributions cap being exceeded.

SMSF borrowing from a related party

The law does not prohibit the lender from being a related party. However, we are likely to apply scrutiny to related-party LRBAs where the terms of the loan, taken together, and the ongoing operation of the loan, are not consistent with what an arm’s-length lender dealing at arm’s length would accept in relation to the particular borrowing by the fund trustee.

Additionally, SMSFs must continue to comply with other legislative requirements. For example, the SMSF must satisfy the sole purpose test and comply with existing investment restrictions such as those applying to in-house assets and prohibitions on acquiring certain assets from a related party of the fund.

See also

• SMSFR 2010/1 Self-Managed Superannuation Funds: the application of subsection 66(1) of the Superannuation Industry (Supervision) Act 1993 to the acquisition of an asset by a self-managed superannuation fund from a related party

Does a borrowing from a related party need to be arm's length?

A trustee of an SMSF or its investment manager must ensure all investments are conducted on an arm's-length basis or, if the parties are not at arm's length, that the terms of the investment are no more favourable to the other party than they would be if the parties were dealing at arm's length.

'Invest' is defined in subsection 10(1) of the SISA to mean applying assets in any way, or making a contract, for the purpose of gaining interest, income, profit or gain.

When entering into the LRBA, the SMSF trustee is investing. Subsection 109(1) of the SISA imposes requirements with respect to transactions relevant to investments made by SMSF trustees. Borrowing money under the LRBA is a transaction entered into in the course of making an investment.

This means that an SMSF trustee or investment manager cannot allow a related party lender to charge the fund more than an arm's-length rate of interest under the arrangement.

The SMSF trustee must be able to demonstrate that the SMSF was not paying in excess of an arm's-length rate of interest to a related party. The calculation of a rate that represents an arm's-length rate of interest needs to be based on reasonably objective and supportable data – for example, the rates charged by arm's-length financial institutions for a similar borrowing.

Paying a member or relative of a member an excessive rate of interest would also contravene the prohibition on SMSF trustees giving financial assistance to members or their relatives using the resources of the SMSF.

See also

• LCR 2021/2 Non-arm's length income - expenditure incurred under a non-arm's length arrangement
• SMSFR 2008/1 Self-Managed Superannuation Funds: giving financial assistance using the resources of a self-managed superannuation fund to a member or relative of a member that is prohibited for the purposes of paragraph 65(1)(b) of the Superannuation Industry (Supervision) Act 1993
• TD 2016/06 Income tax: will the ordinary or statutory income of a self-managed superannuation fund be non-arm's length income under subsection 295-550(1) of the Income Tax Assessment Act 1997 (ITAA 1997) when the parties to a scheme have entered into a limited recourse borrowing arrangement on terms which are not at arm's length?
• PCG 2016/5 Income tax – arm’s length terms for Limited Recourse Borrowing Arrangements established by self-managed superannuation funds

Related parties on-lending money at a higher interest rate

A related party can on-lend money to the SMSF under an LRBA at a higher rate of interest provided the:

• limited recourse loan to the SMSF by the related party is appropriately documented
• SMSF is not charged higher than an arm's-length rate of interest for borrowing
• arrangement under which the SMSF borrows from, the related party otherwise meets the requirements of the super law.

For arrangements entered into on or after 7 July 2010, the super law specifically prohibits the asset being acquired by the SMSF trustee under the arrangement from being used as security for the borrowing of the related party.

Find out if the asset can be used as security (other than for the LRBA).

Loan repayments on behalf of the holding trust

Usually, where an SMSF has an LRBA the SMSF will enter into a loan with the lender directly. However, in highly specific circumstances, an SMSF may maintain the borrowing of another party, such as the holding trust, where the SMSF assumes all the obligations for the borrowing.

Whether such an arrangement complies with section 67A will depend on whether the:

• SMSF has properly assumed the borrowing obligations of the other party
• rights of the lender (or any other person) against the SMSF trustee under the arrangement is limited to only the acquirable asset.

There is also a potential risk of consequential breaches of the in-house asset rule and acquisition from a related party rule if the arrangement is not protected by the LRBA exception.

Accordingly, if your fund has entered into, or is considering entering into, a borrowing arrangement where it has not directly borrowed the money, we strongly recommend you seek advice from an SMSF professional, or contact us for SMSF specific advice.

Drawdowns

Drawdowns from a credit facility are considered a new borrowing

We consider each drawdown of funds, from a loan facility or similar arrangement, a separate borrowing, even if the facility or arrangement makes provision for redraws arising from earlier repayments. This view is more fully explained in paragraph 93 of SMSFR 2009/2.

The terms of a single LRBA may allow multiple drawdowns by the investor. Each drawdown must be reviewed to determine whether the borrowing meets the requirements of the super law applying to the particular arrangement.

If a drawdown is put to a purpose that does not meet the requirements of the super law – for example, the cash is put into a member's account – there is a contravention of the super law (specifically, subsection 67(1) of the SISA). Conversely, if the drawdown is put to a permitted purpose, such as the capitalisation of interest, then it does not result in a contravention of the super law.

See also

• SMSFR 2009/2 Self-Managed Superannuation Funds: the meaning of 'borrow money' or 'maintain an existing borrowing of money' for the purposes of section 67 of the Superannuation Industry (Supervision) Act 1993

Drawdowns to make capital improvements

For real property held by the holding trust in an LRBA, an SMSF trustee may be able draw down under the arrangement – to make capital improvements to the real property – without contravening the super law depending on when the arrangements were entered into.

Arrangements entered into on or after 7 July 2010

Drawdowns for capital improvements are not allowed for arrangements entered into on or after 7 July 2010. The super law applying to these arrangements specifically prohibits borrowing to make improvements under subparagraph 67A(1)(a)(i) of the SISA.

However, drawdowns to capitalise interest, maintain the asset and meet other costs of the arrangement continue to be allowed.

Arrangements entered into on or after 24 September 2007 and before 7 July 2010

Drawdowns for capital improvements are allowed for arrangements entered into between 24 September 2007 and 7 July 2010.

When improvements materially alter the character of the original asset, they create a replacement asset for the purposes of former subsection 67(4A) of the SISA.

Under former subsection 67(4A), the replacement asset is not limited to any particular type of asset but must be an asset that the SMSF trustee is not prohibited from acquiring. Assuming that the original property was an asset that the SMSF trustee was permitted to acquire, the improved property will be a permitted replacement asset.

If the terms of a LRBA allow the SMSF trustee to make drawdowns, then any drawdowns must be used for the acquisition of the original asset or its permitted replacement.

Drawdowns to pay for capital improvements to the original asset meet this test, as do drawdowns to capitalise interest, maintain the asset and meet other costs of the arrangement. However, an SMSF trustee cannot make a drawdown to extract cash from the arrangement.

SMSF trustees must not attach an existing fund asset to the real property or otherwise subject an existing fund asset to a charge under the arrangement.

Find out about borrowing under an LRBA to build a house on vacant land owned by the fund.

Arrangements permitting capitalisation of interest or other borrowing charges

Arrangements entered into on or after 7 July 2010

The super law (specifically, subparagraph 67A(1)(a)(i) of the SISA) applying to these arrangements explicitly provides that, under a LRBA, the SMSF trustee can apply borrowed money towards expenses incurred in connection with the borrowing.

Arrangements entered into on or after 24 September 2007 and before 7 July 2010

Arrangements can be entered into on or after 24 September 2007 and before 7 July 2010, provided the:

• amounts capitalised are costs of the original borrowing (for example, interest or other charges directly incurred under the borrowing)
• original borrowing is applied to acquire the underlying asset
• lender's rights against the fund in the event of a default in repaying the capitalised amounts remain limited to rights relating to that asset (or a replacement asset).

A further amount drawn down under the arrangement to pay interest on the outstanding loan amount or to pay other fees and charges associated with the borrowing is considered to be money applied for the purpose of acquiring the asset.

Lenders recourse and charging the asset being acquired

Granting the lender a right of recourse to the underlying asset at the same time that the trustee of an SMSF acquires the beneficial interest in the asset – is a necessary feature of an LRBA contemplated by the super law.

Granting of such a right in these circumstances will not contravene the existing prohibition in the law against giving a charge over a fund asset, provided the arrangement complies with all the conditions of the super law.

SMSF member personal guarantees to the lender in an LRBA

Arrangements entered into on or after 7 July 2010

An SMSF member can provide a personal guarantee to a lender in an LRBA provided the guarantor's rights against the principal debtor (the SMSF trustee) are limited to rights relating to the asset being acquired under the arrangement.

Under the super law applying to these arrangements, the recourse of the lender or any other person against the SMSF trustees in connection with, or as a result of, a default on the borrowing (either directly or indirectly) must be limited to rights relating to the asset that is being acquired under the arrangement.

This means, for example, that for an arrangement to meet the requirements of the super law, any guarantor must not have general rights of indemnity against the principal debtor (the SMSF trustee) that might crystallise in the event of a call on the guarantee. However, the guarantor may have rights of subrogation of the lender's rights (that is, the right to exercise the lender's limited rights of recourse to the asset being acquired under the arrangement) that might crystallise in the event of a call on the guarantee.

Arrangements entered into on or after 24 September 2007 and before 7 July 2010

The recourse of the lender against the SMSF trustees in the event of a default on the borrowing must be limited to the asset that is being acquired under the arrangement. A third party may put up their own assets as a guarantee to provide additional security to the lender.

It is not required that a third party guarantor waive their usual rights of indemnity against the principal debtor (the SMSF trustee) in the event of a call on the guarantee. However, SMSF trustees should carefully consider the risks to the assets of the SMSF (other than the asset being acquired under the LRBA) that an unlimited guarantee might represent. The rights of indemnity given in favour of a guarantor may be excluded or limited by the express terms of the guarantee.

Personal guarantees and contributions to the SMSF

If a guarantor makes a payment to the lender under an arrangement where they have foregone their usual rights of indemnity against the principal debtor (the SMSF trustee) for the guarantee, this is a contribution to the SMSF if it satisfies a liability of the SMSF. This might happen, for example, if the guarantor paid the borrowing and the acquirable asset was transferred to the SMSF trustee under the arrangement.

In contrast, there is no contribution if the SMSF trustee has exercised a right to walk away from the arrangement (and has lost the acquirable asset to the lender) and has no further liability, but the lender still exercises a right to call on the guarantee for a shortfall after disposal of the original asset.

See also

• TR 2010/01 Income tax: superannuation contributions

Can a related party to the SMSF give a mortgage to the lender over an asset of the related party?

Arrangements entered into on or after 7 July 2010

A related party can give a mortgage to the lender over an asset of the related party provided the related party or any other person has no rights of recourse against the SMSF trustee in the event that the mortgage is exercised by the lender (for example, if the SMSF trustee defaults on the borrowing), other than rights relating to the asset being acquired under the arrangement.

Arrangements entered into on or after 24 September 2007 and before 7 July 2010

Under the super law the recourse of the lender against the SMSF trustees in the event of a default on the borrowing must be limited to the asset that is being acquired under the arrangement.

However, a third party can mortgage one of their assets (in which the SMSF does not have an interest) to the lender to provide the lender with additional security.

Can the asset being acquired be used as security other than for the borrowing by the SMSF trustee?

Arrangements entered into on or after 7 July 2010

Assets acquired after 7 July 2010 cannot be used as security (other than for the LRBA).

The super law (specifically, paragraph 67A(1)(f) of the SISA) applying to these arrangements prohibits any charge over the asset other than for the LRBA.

Arrangements entered into on or after 24 September 2007 and before 7 July 2010

SMSF trustees need to be careful that such a charge over the asset held in the holding trust does not contravene the law.

For example:

• all of the SMSF trustee's dealings about the arrangement must meet the arm's-length requirements in section 109 of the SISA
• no member or relative of a member can be financially assisted by the SMSF trustee using the resources of the SMSF
• the maintenance of the fund must be in accordance with the sole purpose test.

There may be limited circumstances where such a charge does not result in a contravention of the SISA, but for the reasons given above we would not encourage it.