Capital protected borrowing expenses & SMSFs

The much anticipated 2008/09 Federal Budget has now been delivered and despite various rumours that had been circulating in the lead-up to Budget night, there have been no major surprises on the superannuation front. In particular, there have been no announcements made about instalment warrant-type borrowings by SMSFs, indicating that these arrangements will continue to be a major planning opportunity for SMSF trustees and their advisers.

One announcement which may impact borrowing is the lowering of the benchmark interest rate for capital protected borrowings entered into from 13 May 2008, which we explain below.

What are capital protected borrowings?

A borrowing is ‘capital protected’ if the borrower is wholly or partly protected against a fall in the market value of an asset (where the asset is either being acquired via the borrowing, or is being used as security for the borrowing). Often, this is akin to a ‘put option’ (eg, where the borrower is able to force a transfer of the asset to the lender if the asset falls below market value).

Whether a particular borrowing has this element of ‘capital protection’ comes down to the asset being acquired and the terms of the loan agreement.

Under Div 247 of the Income Tax Assessment Act 1997 (Cth), not all of the interest expenses for a capital protected borrowing may be deductible; for some loans, any amount of interest above the ‘benchmark’ interest rate is treated as a payment for a ‘put option’ and is therefore not deductible.

The Federal Government announced that this rate is to be lowered from the RBA’s variable indicator rate for personal unsecured loans (which is broadly the current rate of 14.55%) to the RBA’s variable indicator rate for standard housing loans (currently 9.35%). This means that a greater number of capital protected borrowings are likely to be captured by this new, lower benchmark rate.

Does this affect instalment warrant-type loans?

It should firstly be noted that Div 247 only applies where the asset is an interest in a share, a unit in a unit trust or a stapled security (or an interest in an entity that holds an interest in these). Therefore, Div 247 will not apply in respect of instalment warrant-type loans to acquire real estate and other assets.

Where, eg, shares are involved in an instalment warrant-type product with ‘capital protection’, Div 247 will apply and deny a deduction for any interest above the benchmark (currently 9.35%). The excess is included in the asset’s cost base for calculating any future capital gain or loss.

Focus on SMSFs & unit trusts

Recent material from the ATO suggests SMSF investment in unit trusts (‘UT’) will be under scrutiny. Draft Ruling SMSFR 2008/D1 indicates the ATO may consider an unpaid present entitlement (‘UPE’) owing to an SMSF unitholder for which payment is not sought to be a ‘loan’ from the SMSF to the UT. SMSFs with UPEs owing must be alert to this and seek timely receipt of any UPEs.

Concerns are raised in Taxpayer Alert TA2008/4 that SMSF income derived from ‘hybrid’ UTs may be ‘non-arm’s length income’ (ie, taxed at 45%) if the income is disproportionate to what would be expected if dealing at arm’s length. UT deeds should therefore be reviewed for any ‘hybrid’ or non-fixed element.

SMSFD 2007/1 confirms when a distribution from a pre-1999 geared UT is ‘received’ by an SMSF, which affects when and whether the amount can be reinvested in the UT in the lead up to the deadline for reinvestment in such trusts (broadly a receipt must be reinvested by 30/6/2009).

End of financial year super checklist

Another 30 June is fast approaching. Advisers must ensure they have these items ticked-off before year’s end!