Alternatives to bank borrowing for super

Since the introduction of changes that enable borrowing through SMSFs to purchase investment assets, such as shares and property, Trustees have begun to consider their borrowing options and assess which ones best suit them. While third party lenders such as Banks most commonly spring to mind, a viable opportunity could be to self fund investments.

While there are benefits in considering entering into such arrangements, Trustees must understand the rules that apply to borrowing, as the nature of the relationship between the borrower and a lender, who is a related party, call into question the fund's statutory compliance.

Some of the key issues that trustees need to consider prior to entering into borrowing arrangements with a related party are outlined below:

Satisfying the sole purpose test

Trustees should ensure all terms and conditions of a loan agreement are commercial and that adequate documentation supports the arm's length nature of a loan arrangement with a related party.  Terms of an agreement that are not deemed commercial could result in a breach of the sole purpose test.

Arm's length dealings and interest

All facets of a loan agreement with a related party must be undertaken on an arm's length basis. 

Related parties can not vary the interest rate payable to achieve a better tax result.  The ATO have indicated that if a related party of a SMSF charges a rate of interest greater than commercial rate, the fund may be in breach of the sole purpose test on the basis of not being maintained solely for the purpose of providing superannuation benefits.  It may also be in breach of providing financial assistance to a member or relative using the resources of the fund.

Conversely, if the interest rate charged is below market value, the loan could be characterised as a contribution to the fund.  This could potentially have the adverse tax consequences where the contribution results in a liability for excess non-concessional contributions tax.

Where arrangements are found not to be at arm's length, the income derived from the arrangement could be assessed at the top marginal tax rate, currently 45%.

Personal guarantees

While Banks generally require that a guarantee be provided this can create issues for the borrowing arrangement.  One of the benefits of using a related party lender is that a guarantee will not be required from the trustees or related parties of the SMSF.  However, the downside of not providing a guarantee is that it can make it more difficult to assess a commercial interest rate, which is required to ensure the loan is on arm's length terms.