SMSFs and nil interest loans — the hidden tax consequences
The Australian Taxation Office (ATO) acknowledge on its website that related parties can lend to SMSFs. However, many related parties wish not only to lend to an SMSF, but lend to the SMSF on very friendly terms, including nil interest rates.
Many have said that this arrangement is okay, while others have gone so far as to say that the ATO have approved of nil interest related party loans.
However, one must first consider the full implications of the non-arm’s length income provisions in section 295-550 of the Income Tax Assessment Act 1997 (Cth).
Non-arm’s length income provisions
The non-arm’s length income provisions seem to be the last great sticking point in determining whether to engage in a nil interest loan (ignoring of course part IVA and similar concerns).
If a super fund’s income is deemed to be non-arm’s length income, then it is taxed at 45 per cent.
Broadly, income is non-arm’s length income if:
- it is derived from a scheme to which the parties’ dealings are not at arm’s length and
- it is greater than the amount that would have been expected had the parties been dealing with each other at arm’s length.
The ATO recently considered this in two private binding rulings. At the risk of oversimplifying, these rulings involved SMSFs that had zero per cent interest rate loans from related parties. In both, the ATO concluded that the income derived was not non-arm’s length income.
Naturally, this is very positive news for the taxpayers in those private binding rulings. However, several points must be remembered:
Firstly, a private ruling is a private ruling not a public ruling. Edited versions of private rulings are made public to enhance the integrity and transparency of the ATO decision-making process. They cannot be relied upon as binding the ATO for all taxpayers.
Secondly, not all of the facts in private binding rulings are known and other facts — such as the loan-to-value ratio — could be very important.
Example — non-arm’s length income concern
To illustrate this, consider an SMSF with a very small balance, say, $10,000. If all dealings were at arm’s length, the SMSF might generate a 4 per cent income return, that is, $10,000 x 4 per cent = $400.
Now, assume that a related party lends to the SMSF with a very high loan-to-value ratio and a very low interest rate (ie, non-arm’s length terms that favour the SMSF).
The related party might lend, for example, $1 million. The SMSF now has $1,010,000 and might derive $40,400 (ie, $1,010,000 x 4 per cent). The $40,400 on its face appears to be non-arm’s length income. That is, if all parties were dealing at arm’s length, an SMSF with $10,000 equity would be highly unlikely to purchase a $1,010,000 property and thus the income derived by the property ($40,400 instead of $400 had the SMSF been dealing at arm’s length) could be construed as being non-arm’s length income.
Originally, there was a concern that a related party loan favouring an SMSF would constitute a contribution and therefore give rise to excess contribution tax issues. The ATO in taxpayer alert TA 2008/5 stated that they were concerned about such loans. They said:
"monies advanced by a member or related party at zero or less than a commercial rate of interest could be characterised as a contribution to the SMSF. This may result in the trustee/member having to pay excess non-concessional contributions tax under Division 292 of the Income Tax Assessment Act 1997…"
Although taxpayer alert TA 2008/5 has never been formally withdrawn, the ATO have moved away from this position. See item 7.4 in the June 2012 Superannuation Technical minutes of the NTLG. Here, the ATO said that saving an interest expense (as a result of a favourable interest rate) is not necessarily a contribution and that a nil interest rate will not prevent the arrangement from being a borrowing.
Another important consideration is division 7A of the Income Tax Assessment Act 1936 (Cth). If a related company (or a family trust with an unpaid present entitlement owing to a company) lends to an SMSF, on its face, division 7A operates to make all of the loan assessable income of the SMSF. However an exception is carved out if the loan meets certain criteria (ie, an interest rate in the 2014 financial year of at least 6.20 per cent and other specific requirements are met).
SIS arm’s length requirements
Provided the loan favours the SMSF and does not favour the related party, the ATO seem to take the view that the arm’s length requirements in the SIS legislation are not contravened. See ATO ID 2010/162.
Although limited recourse borrowing arrangements are becoming reasonably well accepted, caution should still be taken, especially with related party loans. Particular care should be taken in respect of non-arm’s length income.
In my opinion if an SMSF wants to engage in a related party borrowing transaction with favorable terms for the SMSF (ie, non-arm’s length terms) at the very least, a private binding ruling should first be sought from the ATO.
Bryce Figot is a director at DBA Lawyers.