SMSF trustees should take care when borrowing money from related parties, says Bryce Figot.
More and more self-managed superannuation fund (SMSF) trustees are engaging in limited recourse borrowing arrangements (formerly called “instalment warrant” borrowings). Many SMSF trustees borrow from banks, but a sizeable number borrow from related parties. Related parties lending to SMSF trustees can be a very powerful strategy. However, it creates more potential for contravening various laws. This article provides guidance on how to ensure a related party borrowing arrangement fully complies with the key element of keeping the arrangement at arm’s length.
The first question is: Why bother borrowing from a related party? Why not just borrow directly from a bank? There are several key reasons. The first is, it increases the wealth of the family group. Consider the following case study.
Jack and Jill have $350,000 cash in their SMSF. The SMSF trustee wants to borrow $650,000 to acquire a $1 million property. Banks are offering to lend to the SMSF trustee at 7.5 per cent per annum. Jack and Jill own their own home. Banks are willing to lend to Jack and Jill at 6.5 per cent per annum. Accordingly, they are considering two different options:
Option 1 – the SMSF trustee borrows the $650,000 directly from a bank at 7.5 per cent per annum.
Option 2 – Jack and Jill personally borrow the $650,000 from a bank at 6.5 per cent per annum (using their home as security) and then Jack and Jill on-lend that money to the SMSF trustee at 7.5 per cent.
Make the following assumptions:
• Jack and Jill are each on a personal marginal tax rate of 30 per cent;
• Jack and Jill each receive $25,000 of concessional contributions into the SMSF each year;
• the property increases in value by 7 per cent each year;
• the property yields a rent of 3 per cent each year;
• all loans are interest-only; and
• in option 2, Jack and Jill would use the interest received from the SMSF to pay the bank.
The table below shows Jack and Jill’s position after 10 years. Accordingly, by engaging in a related party lending strategy, Jack and Jill have increased their wealth by almost $50,000 over 10 years. This $50,000 is from the fact that the “SMSF loan premium” of 1 per cent has stayed in Jack and Jill’s family group. Naturally, the SMSF itself is indifferent to where the money comes from – this is of course because the related party borrowings are at arm’s length.
Net wealth in SMSF $1,363,640
Net personal wealth (excluding value of home) –
TOTAL WEALTH $1,363,640
Net wealth in SMSF $1,363,640
Net personal wealth (excluding value of home) $48,506
TOTAL WEALTH $1,412,146
It is important to note that the interest that the fund pays to Jack and Jill will be included in their personal income tax returns. However, generally speaking, the interest expense on the loan from the bank should be deductible to Jack and Jill.
Accordingly, Jack and Jill do not receive any tax benefit – in fact, Jack and Jill personally pay more tax under option 2, but this is a happy result of Jack and Jill receiving more net income.