Prudent person test a must in any SMSF loan arrangement: legal expert

However, he said in every case and with every investment the trustee of the SMSF must be satisfied it’s a proper investment for the SMSF – it must pass the “prudent person test”.

“We have to make sure it complies with the investment strategy,” he said.

“There’s a couple of other things still to think about when talking about loans in an SMSF, one of which is the sole purpose test, which stipulates the SMSF must be maintained for the sole purpose of providing retirement benefits to members and not for other purposes.”

That sole purpose test also stated that the fund’s members, their families and related entities must not benefit pre-retirement from the SMSF.

Hay-Bartlem said that loans to members and other entities are often attacked as a breach of the sole purpose test.

Regarding a loan to someone who is not technically a related party, Hay-Bartlem said the rules are simpler as many restrictions don’t apply. However, the loan must still pass the prudent person test and satisfy other conditions, such as ensuring that it is made on normal commercial arm’s length terms as to repayments, interest, guarantees and security.

Where the borrower is a related party of the SMSF, there are several specific restrictions to deal with including the in-house asset rules.

“An in-house asset includes a loan to a member or a related party of a member and if an SMSF loans any amount to a member or a related party, it will be an in-house asset,” he said.

“You can have up to 5 per cent of the value of the fund’s assets in in-house assets, so it’s important to check to make sure it passes that 5 per cent rule. It’s not an absolute prohibition, but what is often missed is that there’s another provision in the super rules.”

He added that the provision is Section 65, which says that an SMSF cannot make a loan to a member or a relative or give other financial assistance using the resources of the fund.

“Even though you might have a loan to a member, which is an in-house asset and under the 5 per cent, an SMSF still can’t do it because it is a breach of Section 65,” he said.

“That includes loans to members or relatives directly, but because of that other financial assistance part of the rules, it’s also going to stop a fund making loans to other related entities where its members or relatives are going to benefit from it.”

Hay-Bartlem said an SMSF will also have to prove with any loan that it has been made on normal commercial terms with consideration as to what an arm’s length bank would do.

“Would they make the loan at all? What would the interest rate be? It would be documented. Would there be guarantees? Would there be security?” he said.

“If you don’t get all of those things right with the related party loan, even if you sneak through one of the specific prohibitions, you still have problems with compliance for the SMSF.”