Why you shouldn’t borrow from a self-managed super fund

Many small businesses are currently doing it tough. Finance, including credit, has become more difficult to obtain, and trading conditions are often just plain difficult. So, where to turn for help?

One source can be the self-managed super fund (SMSF) of one or both of the business owners. But, there are grave traps in this potentially lucrative source of funding, as a recent decision by the Administrative Appeals Tribunal (AAT) has revealed (the case was AAT Case [2009] AATA 522, Re JNVQ and FCT).

The background to the case was that, in 2004-05, the husband and wife trustees of a self-managed super fund made loans to the husband’s company (a “related party” of the fund) which was experiencing financial difficulties.

The loans totalled $211,000 and exceeded 95% of the fund’s total assets – well in excess of the 5% in-house assets limit stipulated by the superannuation laws. In July 2007, the fund’s auditor lodged a contravention report with the Tax Office advising that the fund had contravened the in-house assets rules.

The Commissioner issued a non-compliance notice under the superannuation laws in July 2008 after rejecting the fund’s offers of enforceable undertakings. The Commissioner considered that the trustees’ proposed timeframes for repaying the loans were set too far into the future. The loan was outstanding until 2009, when the company paid back the balance of $86,000.

The company was going through a difficult period, when the company’s usual banker refused further finance. Being able to access the loan from the super fund enabled the company to continue trading. The trustees admitted they were aware that they were contravening the law, but said they had intended to repay the loan promptly. As events transpired, however, they were unable to do so.

One aspect of the difficulties was that it was taking some time for the company to find alternative finance. This put the company under financial pressure: suppliers withdrew credit and cashflows were affected. Not an uncommon scenario.

During this time, the husband (the trustee/company manager) was suffering from ongoing chronic illness, which affected his ability to manage the company’s operations. Added to this, the company’s premises sustained damage in cyclones in 2004 and 2005, and those natural disasters were followed by a general downturn in trading in the region.

Additionally, there were problems in other parts of the family businesses, including outstanding tax debts on which the Tax Office issued payment demands. So, there were clearly a set of difficult circumstances involved in the case. The husband and wife considered placing the company into administration or borrowing from the fund. They decided on the latter option.

The super fund’s trustees sought a review of the Commissioner’s decision not to exercise his discretion under the superannuation laws to treat the fund as a complying fund despite the contravention of the in-house assets rules. The trustees submitted that the particular circumstances surrounding the loan, combined with the declining fortunes of their related business at the time, as well as other personal factors, were such to warrant a favourable exercise of the discretion. In this respect, the trustees argued that the Commissioner gave too much weight to “the seriousness of the contravention” without having due regard to their particular circumstances.

Once a fund is found to be non-compliant, it loses access to concessional tax treatment and its taxable income is assessed at the top marginal rate. In the year a previously complying fund becomes non-complying, its income includes the assets of the fund less any undeducted contributions, thereby recouping all previously allowed tax concessions.

This is a severe penalty that anyone operating a fund must be aware of. A super fund that loses its complying status will generally become liable for tax at the rate of 45%.

The AAT’s decision

In upholding the Commissioner’s decision to issue the notice of non-compliance, the AAT ruled that the seriousness of the contravention, and the length of time taken to redress it, weighed heavily against exercising the discretion to treat the fund as complying, despite the contravention.

The AAT rejected the trustees’ argument that the Commissioner had given too much weight to “the seriousness of the contravention” without having due regard to the other relevant considerations required under the law. The discretion allows the Commissioner to consider the following factors:

• the taxation consequences arising if the fund is treated as non-complying,
• the seriousness of the contravention, and
• all other relevant circumstances,

in order to decide whether, despite the contravention, the fund should be declared complying nevertheless, and so retain its concessional taxation status.

The AAT acknowledged the husband’s health issues, the impact of cyclones in North Queensland in 2004-05 and outstanding tax debts in other parts of the family businesses, but said those factors were only relevant considerations up to a certain point, and not throughout.

The AAT also said that “all relevant circumstances” are not simply those that work in favour of the applicant. Accordingly, the AAT noted that the balance of the loan remained outstanding for more than four years after the initial breach, while the trustees had funded other commercial property developments in other parts of their business. For instance, they invested in the purchase of a commercial site and undertook a strata project in 2007. Yet, no serious attempt was made to rectify the breach.

Furthermore, the AAT said the trustees had the assistance of professional advisers who had suggested putting the company into administration. However, the AAT found the trustees instead chose to use the fund as “a line of credit to prop the company up, in an attempt to trade through its difficulties”.

ATO warns fund trustees

Tax Commissioner Michael D’Ascenzo said the decision is a reminder to trustees to act on any breaches. “The sole purpose of an SMSF is to provide benefits for members in retirement and should not be used to invest in related parties above the 5% in-house asset limit,” Mr D’Ascenzo said.

The Commissioner reminded trustees of the seriousness of such a breach, and of the need for trustees to act urgently to remedy the situation. He also said the Tax Office has increased its focus on ensuring high levels of compliance among trustees, given the important role of SMSFs and their access to concessional tax treatment.

Be aware of the rules

Anyone operating a self-managed super fund should take careful heed of the AAT decision. Yes, the Commissioner has a discretion available to him under the law to treat a fund as complying, notwithstanding that it has contravened the law. But the exercise of that discretion depends on the circumstances of each case. It should not be taken for granted.

The Tax Office has even released a Practice Statement (PS LA 2006/19) on self-managed superannuation funds which outlines the factors the Commissioner will consider in deciding whether a notice of non-compliance should be given to a fund. That Practice Statement indicates that a notice of non-compliance will not be given to a fund if the Commissioner accepts an undertaking by the trustee to rectify a contravention. Unfortunately, in the case before the AAT, the husband and wife fund trustees had declined those offers.

There were over 400,000 self-managed super funds in existence in March 2009, holding over $300 billion in funds. They are small funds with fewer than five members, where all members of the fund are also the trustees responsible for controlling the administrative and investment decisions of their fund.

SMSFs must comply with similar requirements imposed on all regulated superannuation funds to maintain their complying fund status to enjoy concessional tax treatment. It cannot be too strongly stressed that funds which breach the strict regulatory requirements may lose their complying fund status with the fund potentially taxed as a non-complying fund at 45%, instead of 15%. In addition, SMSF trustees may be personally subject to a range of civil and criminal penalties in relation to any breaches of the law.

Running a self-managed super fund can bring great benefits, but be aware of the rules.

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