30/09/2010

The ATO ID 2010/62 has provided a favourable interpretation to section 109 of the Superannuation Industry (supervision) Act 2003 (“SIS Act”).  It provides further scope for SMSF borrowing and investment strategies.

Where the superannuation fund and the other party in an investment transaction are not dealing at arm’s length, section 109 requires that the terms and conditions of the transaction should be “no more favourable to the other party than those which it is reasonable to expect would apply if the trustee or investment manager, as the case may be, were dealing with the other party at arm’s length in the same circumstances.”

In ID 2010/162, the ATO considers that “while the terms of the transaction cannot be more favourable to the non arm’s length or related party than would have been the case had the parties been dealing at arm’s length,  there is no contravention of section 109 if the terms are more favourable to the SMSF.”

The ATO view is consistent with APRA’s interpretation in APRA Circular II.D.5.  In relation to section 109, it was stated “for instance, the purchase price of an investment should be at market value or a value more favourable to the (superannuation) fund than to the other party.”

While section 109 was enacted to ensure that superannuation funds will not be disadvantaged in relation to related party transactions, it also has the effect of allowing members to shift value to the SMSF by structuring transactions on terms and conditions that are more generous or favourable to the SMSF.  The value shifted from the member to the SMSF is likely to be treated as a deemed contribution.  This aspect will be discussed below, in conjunction with other relevant aspects.

Implications

1.     In the context of SMSF limited recourse borrowing, value shifting under section 109 may happen through:

• Internal lending arrangements where the lender is a related party and the interest rate of the loan to the SMSF is lower than the market rate of interest.
• The single acquirable asset under the borrowing arrangement may be an asset that the SMSF is allowed to acquire from a member or related party, for example, business real property.  The purchase price can be set at a level that is favourable to the SMSF i.e. less than market value.
  

2.     Subject to the investment strategy, a back to back borrowing arrangement may potentially add further value.  This is an arrangement where the member borrows from a financial institution at market rate of interest and on-lends to the SMSF under the limited recourse borrowing exception of Section 67A of the SIS Act.  The loan from the member to the SMSF may be set at an interest rate that is lower than the market rate.

• The interest on the loan taken out by the member to finance lending to the SMSF will be tax deductible to the member.  Whereas if a member borrows to make contribution to superannuation, the interest is generally not tax deductible.
• The SMSF also obtains a tax deduction for the interest on the limited recourse loan paid to the member, to the extent allowable under protected borrowing arrangements.
• Salary sacrifice or deductible personal contributions may further enhance the tax deductions available.
  

3.    Example:  Member ‘A’ borrows $200,000 from a financial institution at the interest rate of 9%.  He on-lends the $200,000 to his SMSF under a limited recourse borrowing arrangement at the interest rate of 5%.  He makes concessional personal contribution of $5,000 to superannuation.

Member ‘A’s income and tax deductions in a year of income under this arrangement are:
Tax deductions:     

$18,000 (interest paid to financial institution)
$  5,000 (assessable personal contribution)
$23,000

Assessable income:  $10,000 (interest on loan paid to Member ‘A’ by SMSF)

The excess of deductions over income is $13,000 which member ‘A’ can use to offset other assessable income. 

The value shifted by Member “A” to the SMSF in the year of income representing the interest foregone by the member is a deemed contribution.

4.     In ID 2010/1, the ATO considers that an indirect increase in capital of the fund is a contribution. “It may take the form of increasing the value of an asset of the fund through a value shifting arrangement that transfers value from an asset held by another.”  Therefore the value shifted by the member to the SMSF under the above arrangement is a deemed contribution.

5.    Related party lending may have implications under Division 7A of the Income Tax Assessment Act 1936 and has to be structured properly.

6.    The ATO also considers that all other aspects of the limited recourse borrowing arrangement, apart from the interest rate component, has to be documented and conducted in a business-like manner in the same way as an arrangement when dealing with at an arm’s length.

7.    The structuring of SMSF limited recourse borrowing arrangements must also take into consideration other requirements of the SIS Act and the governing rules of the SMSF.

From 7 July 2010, SMSFs will only be allowed to gear into a “single acquirable asset” consisting of either a single asset or a collection of identical assets of the same market value.  Gearing into a portfolio of shares will no longer be possible, although arrangements grandfathered under the former section 67(4A) of the SIS Act will be allowed to continue in accordance with its terms, until the arrangement comes to an end or re-financing of the loan takes place.  Gearing into a direct real property will meet the single acquirable asset requirement under the new rules and this may become the focus of SMSF gearing in the future.

It has to be borne in mind that SMSF limited recourse borrowing is an exception to the general rule that regulated superannuation funds should not be allowed to borrow. Borrowings generally increase investment risks which may adversely affect retirement benefits.  It is an area where the legislation and interpretations will continue to evolve.  The Cooper Review Final Report recommends that SMSF borrowing arrangements should be reviewed in two years time to ensure that borrowing has not become a significant focus of SMSFs.

TOWNSENDS BUSINESS & CORPORATE LAWYERS has published a  technical paper and a gearing handbook that embody all aspects of the new limited recourse rules under Sections 67A and 67B of the SIS Act, as well as the grandfathered arrangements under the former section 67(4A).  A complete establishment package on SMSF limited recourse borrowing is also available including detailed advice on the following:

• Security trust deed
• Loan Agreement
• Mortgage documentation
• Advice letter to clients
• Trustee minutes
• Stamp Duty advice
  

For assistance in this area, please contact us on (02) 8296 6222.