Another key reason for opting for a related party is administrative efficiency. Due to the bureaucracy of large SMSF lenders, even if everything is completely in order it can still take many weeks before a property can settle. Some SMSF trustees do not have the luxury of time; related party loans can be implemented in a fraction of the time (especially where the related party is already cashed up and does not itself need to borrow from a bank).
WHAT DOES THE ATO SAY?
The Australian Taxation Office (ATO) acknowledges that it is allowable for related parties to lend to SMSF trustees. They make the following (non-binding) comments:
IS A SMSF ALLOWED TO BORROW FROM A RELATED PARTY?
The law does not prohibit the lender from being a related party. However, SMSFs must continue to comply with other legislative re- quirements.
For example, the SMSF must satisfy the sole purpose test and comply with existing invest- ment restrictions, such as those applying to in-house assets and prohibitions on acquiring certain assets from a related party of the fund.
ON-LENDING TO AN SMSF
Can a related party borrow on a full recourse basis and on-lend the money to the SMSF under a limited recourse borrowing arrangement at a higher rate of interest?
Yes, provided:
• the limited recourse loan to the SMSF by the related party is appropriately documented;
• the SMSF is not charged more than an arm’s length rate of interest for borrowing;
• the arrangement under which the SMSF borrows from the related party otherwise meets the requirements of the super law.
Accordingly, the ATO highlights that the strategy can be allowable, but care must be taken to cross the “t”s and dot the “i”s.
THE TEST OF ARM’S LENGTH
It is vital that the terms of the loan be at arm’s length. From a superannuation law point of view, something is at arm’s length if a prudent person, acting with due regard to his or her own commercial interests, would have done it.
It is vital to bear this test in mind when selecting a loan-to-value ratio (LVR) and the interest rate.It is also vital to ask how you would prove that this test has been met if audited by the ATO. The best proof is a written offer from a bank to lend to the SMSF trustee on the same terms (that is, documented evidence that you have benchmarked against what a bank would offer).
LOAN-TO-VALUE RATIO
Theoretically, a prudent person, acting with due regard to his or her own commercial interests, might lend with an LVR of 100 per cent. However, in practice this would be very rare and no doubt such lenders would charge a hefty interest premium. This would get an SMSF into a catch-22 because, if a related party is charging an SMSF trustee a hefty interest premium, then the arrangement might alternatively be construed as an early access scheme. Accordingly, from a practical point of view, it’s best to stay within the same LVRs that banks offer. As a rough rule of thumb in respect of real estate, any LVR less than 70 per cent is fine. An LVR between 70 and 80 per cent might be allowable, but the SMSF trustee would definitely have to have very strong evidence supporting this. Anything higher than 80 per cent starts to be fairly “on the nose”.
INTEREST RATES
Interest rates should reflect the fact the loan is of a limited recourse nature, and thus a risk premium on the interest is charged. Again, the best practice is usually to benchmark against what the SMSF trustee could have received from a bank and retain written evidence of this.
The next question is how to describe the interest rate. Consider the following different options to describe interest rates:
• Option 1 – x percent
• Option 2 – Division 7 A benchmark interest rate
• Option 3 -the lender’s cost of finance
