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Related parties can lend to SMSFs. However, it is critical to watch out for non-arm\u2019s length income. The solution is to benchmark. But how do you benchmark in situations where banks won\u2019t lend? This is particularly an issue where the asset being acquired is units in a reg 13.22C unit trust.<\/p>\n
I have a solution! (Naturally, this solution is subject to an important disclaimer: see below.)<\/p>\n
Late last year, the ATO released two interpretive decisions of what not<\/em> to do: ATO ID 2014\/39 and ATO ID 2014\/40. The SMSFs in both of these ATO IDs ended up with non-arm\u2019s length income.<\/p>\n The ATO then clarified on their website:<\/p>\n To be able to demonstrate that NALI does not arise, a fund trustee entering into an LRBA with a related-party borrower should obtain and keep documentation that enables them to establish that the terms of the loan, taken together, and the ongoing operation of the loan are consistent with what an arm\u2019s length lender dealing at arm\u2019s length would accept in relation to the particular borrowing by the fund trustee.<\/p>\n In short, the ATO seem to want benchmarking. Naturally, this makes sense.<\/p>\n The gold standard no doubt is to go to a bank \u2014 or even a number of banks \u2014 and get a written quote for the interest rates, loan-to-value ratio and other terms that the bank would use when lending. Then, ideally one should replicate those terms in the related party loan.<\/p>\n However, there are certain instances where banks simply won\u2019t lend to an SMSF. This is not because it is prohibited for SMSFs to borrow in such circumstances. Rather, it seems to be more to do with banks\u2019 conservative policies.<\/p>\n Two common situations are as follows:<\/p>\n (For completeness, I do acknowledge that sometimes a bank will lend in these circumstances. However, that is so rare that \u2014 if you will forgive the bad pun \u2014 we should not \u2018bank on it\u2019.)<\/p>\n Naturally, if the interest rate is right an arm\u2019s length party will lend in these circumstances, but what is that \u2018right\u2019 interest rate and how do you prove it?<\/p>\n My co-director Daniel Butler and I regularly present SMSF Strategy Seminars all around the country to some of the top SMSF advisers. In February\u2013March 2015 we presented 15 such SMSF Strategy Seminars, both for DBA Network Pty Ltd and for CPA Australia.<\/p>\n In these seminars we administered the following survey:<\/p>\n You receive legal advice that if you exercised your mortgagee powers in respect of the tenants in common interest in the real estate, you could probably easily obtain a partitioning order by sale under which you can force the co-owner to sell at auction their half along with your half and then you split the proceeds.<\/em><\/p>\n SCENARIO 2: BORROWING TO ACQUIRE UNITS IN A UNIT TRUST<\/em><\/strong><\/p>\n Facts<\/em><\/strong><\/p>\n The trustee of a completely arm\u2019s length, unrelated SMSF asks you to lend to it in the following circumstances under an LRBA:<\/em><\/p>\n You receive legal advice that if you exercised your mortgagee powers in respect of the units, you could appoint whoever you wished as the trustee of the unit trust and then the assets of the unit trust would effectively be yours.<\/em><\/p>\n Naturally interest rates change over time. An interest rate that is an arm\u2019s length now might not be arm\u2019s length in several years\u2019 time.<\/p>\n We of course wanted to obtain data that would still be relevant in the future.<\/p>\n That is why we didn\u2019t simply ask people what the interest rate would be. Rather, we asked them what margin in addition to the RBA cash rate target they would use. Pursuant to monetary policy, it is by moving the RBA cash rate target that the RBA seeks to move all other interest rates in the economy. Accordingly, if a related party LRBA interest rate is expressed in relation to the RBA cash rate target (ie, RBA cash rate target plus a certain margin), as the RBA cash rate target moves, the related party LRBA interest rate hopefully should move in what is hopefully an arm\u2019s length manner.<\/p>\n The answers were as follows:<\/p>\n Scenario 1<\/em><\/p>\n The average (ie, the arithmetic mean) of the margin that should be added to the RBA cash rate target in scenario 1 is 7.24%. That is, we suspect that if a related party were lending to an SMSF in the following circumstances, non-arm\u2019s length income would not<\/em> arise.<\/p>\n For those who are more statistically minded, the median of the margin was 7% and the mode 6%.<\/p>\n Scenario 2<\/em><\/p>\n The average of the margin that should be added to the RBA cash rate target in scenario 2 is 7.93%. That is, we suspect that if a related party were lending to an SMSF in the following circumstances, non-arm\u2019s length income would not<\/em> arise.<\/p>\n The median and the mode were both 8%.<\/p>\n I reasonably (ie, for the reasons set out above) believe that the above are the arm\u2019s length terms.<\/p>\n However, of course, there is the disclaimer. Namely, the above is all care no responsibility. It is provided as an instructive and educational example only. It is not provided in order to be relied upon. We make no representations whatsoever that the above is a silver bullet solution to protect from non-arm\u2019s length income, or any other issues.<\/p>\n * * *<\/p>\n This article is for general information only and should not be relied upon without first seeking advice from an appropriately qualified professional.<\/p>\n\n
The solution<\/h3>\n
SCENARIO 1: BORROWING TO ACQUIRE PART OF A PROPERTY<\/strong>Facts<\/em><\/strong>The trustee of a completely arm\u2019s length, unrelated SMSF asks you to lend to it in the following circumstances under an LRBA:<\/em><\/p>\n\n\n
\n Asset being acquired<\/td>\n a 50% tenants in common interest in real estate<\/td>\n<\/tr>\n \n Personal guarantees<\/td>\n Yes: from both SMSF members (at least one owns a valuable, unencumbered home)<\/td>\n<\/tr>\n \n Mortgage granted over asset SMSF acquiring<\/td>\n Yes (over the asset being acquired)<\/td>\n<\/tr>\n \n Amount being borrowed<\/td>\n $1.5 million<\/td>\n<\/tr>\n \n Length of loan<\/td>\n 15 years<\/td>\n<\/tr>\n \n Type of loan<\/td>\n Principal & interest<\/td>\n<\/tr>\n \n LVR<\/td>\n 100%<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n Question<\/em><\/strong>What would be the lowest interest rate that would entice you to agree to lend on the above terms?<\/em>RBA cash rate target (2.25% currently) + \u00a0<\/span> % = \u00a0<\/span> % (currently)<\/em><\/div>\n\n\n
\n Asset being acquired<\/td>\n 100% of all units in a unit trust (unit trust will use cash from issuance of units to acquire and develop real estate)<\/td>\n<\/tr>\n \n Personal guarantees<\/td>\n Yes: from both SMSF members (at least one owns a valuable, unencumbered home)<\/td>\n<\/tr>\n \n Mortgage granted over asset SMSF acquiring<\/td>\n Yes (over the asset being acquired)<\/td>\n<\/tr>\n \n Amount being borrowed<\/td>\n $1.5 million<\/td>\n<\/tr>\n \n Length of loan<\/td>\n 15 years<\/td>\n<\/tr>\n \n Type of loan<\/td>\n Principal & interest<\/td>\n<\/tr>\n \n LVR<\/td>\n 100%<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n Question<\/em><\/strong>What would be the lowest interest rate that would entice you to agree to lend on the above terms?<\/em>RBA cash rate target (2.25% currently) + \u00a0<\/span> % = \u00a0<\/span> % (currently)<\/em><\/div>\n<\/div>\nThe \u2018longevity\u2019 of the answers<\/h3>\n
The answers<\/h3>\n
\n\n\n
\n Asset being acquired<\/td>\n a 50% tenants in common interest in real estate<\/td>\n<\/tr>\n \n Personal guarantees<\/td>\n Yes: from both SMSF members (at least one owns a valuable, unencumbered home)<\/td>\n<\/tr>\n \n Mortgage granted over asset SMSF acquiring<\/td>\n Yes (over the asset being acquired)<\/td>\n<\/tr>\n \n Amount being borrowed<\/td>\n $1.5 million<\/td>\n<\/tr>\n \n Length of loan<\/td>\n 15 years<\/td>\n<\/tr>\n \n Type of loan<\/td>\n Principal & interest<\/td>\n<\/tr>\n \n LVR<\/td>\n 100%<\/td>\n<\/tr>\n \n Interest rate<\/td>\n RBA cash rate target (2.25% currently) + 7.24% = 9.49% (currently)<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<\/div>\n \n\n\n
\n Asset being acquired<\/td>\n 100% of all units in a unit trust (unit trust will use cash from issuance of units to acquire and develop real estate)<\/td>\n<\/tr>\n \n Personal guarantees<\/td>\n Yes: from both SMSF members (at least one owns a valuable, unencumbered home)<\/td>\n<\/tr>\n \n Mortgage granted over asset SMSF acquiring<\/td>\n Yes (over the asset being acquired)<\/td>\n<\/tr>\n \n Amount being borrowed<\/td>\n $1.5 million<\/td>\n<\/tr>\n \n Length of loan<\/td>\n 15 years<\/td>\n<\/tr>\n \n Type of loan<\/td>\n Principal & interest<\/td>\n<\/tr>\n \n LVR<\/td>\n 100%<\/td>\n<\/tr>\n \n Interest rate<\/td>\n RBA cash rate target (2.25% currently) + 7.93% = 10.18% (currently)<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<\/div>\n The disclaimer!<\/h3>\n
\nRefer to the following for other related articles:<\/p>\n\n
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