ATO warns DIY super fund members on trust loan trap

The rapid growth in self-managed super funds (SMSFs) probably acknowledges that many business people (and others) want to control their own financial destiny. That’s no bad thing, but those who use these types of funds must remember that the laws governing SMSFs are strict, and the regulator – the Tax Office – is on the lookout for dodgy practices and funds breaching the law.

It’s something of a minefield that SMEs need to be particularly careful about. There are rules about lending to fund members and relatives, the sole purpose test, restrictions on borrowing and other restrictions.

The Tax Office has recently warned about arrangements whereby a self-managed fund invests money in an unrelated trust that then on-lends the funds to an SMSF member or relative.

The Tax Office considers that such arrangements seek to circumvent the prohibition under the superannuation laws on SMSF trustees lending money or providing financial assistance to a member or a relative of the member, using the resources of the fund.

Lending via unrelated trusts

So exactly what is the ATO concerned about? The arrangements the Tax Office is concerned about have the following features:

• An organiser sets up a trust which purports to offer fixed-rate interest-yielding investments to allegedly unrelated entities.
• An SMSF invests in the trust.
• The organiser (who may also be the trustee of the trust) or a licensee/franchisee of the organiser, sources borrowers to borrow funds from the trust.
• The borrowers may include a member of the SMSF that invested in the trust or a relative of an SMSF member.
• Each borrower enters into a loan agreement with the trust. The loan amount (or total loan amounts of all borrowers associated with the SMSF) may be comparable to the amount the SMSF invested in the trust.
• Terms of the loan may include: (a) a range of available interest rates; (b) a range of interest payment terms, including flexibility in the repayment date (provided the funds are paid sometime in the future); (c) security over the loan in the form of a mortgage, personal guarantee or caveat; and/or (d) the use of borrowed funds for multiple purposes, including business, investment or personal use.
• Each borrower makes interest-only repayments on the loan to the trust for a substantial period of the loan.
• The trustee of the trust pays the SMSF an interest yield on their purported investment.
• Investment and loan fees payable under the arrangement may be considered excessive.

Tax Office concerned about breaches of law

The Tax Office considers that such arrangements may involve a breach of the following superannuation laws:

• The sole purpose test, which says that a fund must be run for the sole purpose of providing certain benefits to its members. The Tax Office applies this test strictly.
• The prohibition on trustees from lending money or giving any other financial assistance to a fund member or relative.
• Members of the SMSF may have illegally accessed superannuation benefits if they do not repay the loan from the trust.
• The requirements that SMSF investments are made and maintained on an arm’s length basis.
• The SMSF’s investment in the trust may be an in-house asset and therefore subject to the 5% limit specified under the law. It’s a little complicated (surprise, surprise!) but, essentially, the rule means that fund trustees must not acquire new in-house assets if this would increase the ratio of such assets to over 5% of total assets of the fund. In-house assets include loans to a related party of the fund, and an investment in a related trust of the fund.

The Tax Office also considers that a loan or financial assistance through another entity may contravene the superannuation laws and result in the SMSF becoming a non-complying superannuation fund. The Commissioner also warned that trustees of super funds who provide financial assistance in this way face penalties of up to $220,000 ($1.1 million for corporate trustees) and/or jail terms of up to five years for individuals. These penalties are not small beer!

Tax issues of concern to the ATO

The Tax Office also considers that such arrangements give rise to a number of tax issues:

• Income derived by the SMSF may be “non-arm’s length income” under tax law which is taxed at 45% (instead of 15%).
• Payment of interest above the commercial rate by the fund member/relative of the member to the trust, which is subsequently paid to the SMSF as an investment yield, may in fact be superannuation contributions for excess contributions tax purposes.
• Any fee or commission received by the trust, licensee/franchisee and/or organiser of this arrangement may be assessable income for the relevant income year.
• Whether the tax anti-avoidance rules may apply to the arrangement.

The ATO said it is currently examining these arrangements. No doubt we’ll hear more about this.

Note that further guidance on the prohibition against giving financial assistance using the resources of a SMSF to a member or relative is set out in an ATO Ruling – Ruling SMSFR 2008/1.

It’s painful to acknowledge that, like tax law, the law surrounding the setting up and running of self-managed super funds is long and complex, although that seems to be a given these days.

ATO warnings about the use of such funds should be taken seriously. Self-managed funds certainly give their owners a degree of independence and control, but they must be sure they know the rules.

Terry Hayes is the senior tax writer at Thomson Reuters, a leading Australian provider of tax, accounting and legal information solutions .

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