The related-party loan labyrinth

Related-party loans are a complicated compliance area for SMSFs. Smarter SMSF technical and education manager Tim Miller examines some of the intricate details pertaining to these arrangements.

SMSF trustees transact with related parties on a regular basis, but it is uncertain if they are aware of the restrictions and prohibitions attached to certain of these types of dealings and, by extension, the consequences of doing the wrong thing.

The ATO has released an annual SMSF statistical report every year since at least 2008/09, providing an update on the number and types of contraventions lodged each year. Loans and/or financial assistance using fund resources to members or relatives of members has consistently ranked as the number one breach committed by trustees and you only have to look at recent case law to appreciate financial assistance can take many forms, but more on that later.

It’s appropriate to understand what the law and the regulator have to say about loans and financial assistance.

The law

Section 65 of the Superannuation Industry (Supervision) (SIS) Act prohibits super funds, including SMSFs, from providing financial assistance to members or their relatives:

“The trustee or an investment manager of a regulated superannuation fund must not:

a. lend money of the fund to:

i. a member of the fund, or

ii. a relative of a member of the fund, or

b. give any other financial assistance using the resources of the fund to:

i. a member of the fund, or

ii. a relative of a member of the fund.”

Related individuals

For the purposes of this article, but perhaps also as a handy reference, members and relatives will herein be referred to as ‘related individuals’. This is an important distinction because a loan to a related party is considered an in-house asset under Part 8, section 71 of the SIS Act and therefore subject to a 5 per cent investment restriction. However, section 65 states nothing in Part 8 shall have any bearing on the prohibition. In other words, section 65 overrules section 71.

Practical implications

The effect of this restriction not only means SMSFs are unable to lend money to related individuals, but also related individuals cannot use fund assets without providing appropriate commercial consideration to the fund, such as paying commercial rent for the use of any direct property. In certain circumstances the use of fund assets by a member or relative will be strictly prohibited, such as collectables and personal-use assets.

An important reminder when dealing with any transaction, specifically when contemplating investment restrictions, is there are many restrictions and all legislative provisions must be reviewed when considering investment transactions, not just the obvious ones.

As an example, the use of SMSF fund assets by members or their relatives for no or reduced cost could be considered to be providing financial assistance to the related individual. It may also cause the sole purpose test and/ or the in-house asset and/or the arm’s-length standards to be breached.

ATO rulings

The ATO previously issued SMSF Ruling (SMSFR) 2008/1 on the application to SMSFs of the prohibition regarding giving financial assistance to members or relatives. The interpretation is extremely broad and, when determining if ‘financial assistance’ exists, can also extend to interposed third parties or entities, that is, indirect assistance. This is where the link between the in-house asset rules and those governing loans to members start to blur.

Example

If a fund lends money to a related company, let’s say Super Investor Pty Ltd, this would appear on face value to be in accordance with the in-house asset requirements. If, however, Super Investor Pty Ltd then on lends the money to a related individual, then it is clearly in breach of section 65.

SMSF trustees should ensure they are aware of ATO SMSFR 2008/1 to seek clarity on financial assistance, but should also use other ATO resources that contemplate whether a transaction could be in breach of section 65. While not an exhaustive list, SMSFR 2009/4 provides the definition of a loan for in-house asset purpose, whereas Taxpayer Alert (TA) 2010/5 and SMSF Regulator’s Bulletin (SMSFRB) 2021/1 look at more nuanced scenarios, such as using unrelated trusts or providing financial assistance through property development.

SMSFR 2008/1 highlights

In the ruling, the ATO sets out a number of transactions or arrangements it would and would not consider as providing financial assistance.

Transactions that the tax commissioner would consider to contravene the lending provisions are:

i. giving a gift of an SMSF asset to a member or relative of a member,

ii. selling an SMSF asset for less than its market value to a member or relative of a member,

iii. purchasing an asset for greater than its market value from a member or relative of a member,

iv. acquiring services in excess of what the SMSF requires from a member or relative of a member,

v. paying an inflated price for services acquired from a member or relative of a member,

vi. forgiving a debt owed to the SMSF by a member or relative of a member,

vii. releasing a member or relative of a member from a financial obligation owed to the SMSF, including where the amount is not yet due and payable,

viii. delaying recovery action for a debt owed to the SMSF by a member or relative of a member,

ix. satisfying, or taking on, a financial obligation of a member or relative of a member,

x. giving a guarantee or an indemnity for the benefit of a member or relative of a member, and

xi. giving a security or charge over SMSF assets for the benefit of a member or relative of a member.

Factors that assist in determining whether the law has been contravened include:

• the arrangement or transaction exposes the SMSF to a credit risk or exposes the SMSF to a financial risk of a member or relative of a member,

• the arrangement or transaction is on nonarm’s-length terms that are favourable to a member or relative of a member,

• the arrangement or transaction is not a usual or normal commercial arrangement in the context in which SMSFs operate,

• the arrangement or transaction is not consistent with the investment strategy of the SMSF,

• under the arrangement or transaction an amount is paid by the SMSF, and later repaid to the SMSF, in amounts or in a manner that may be equated with the repayment of a loan whether with or without an interest component, and

• the arrangement or transaction results in a diminution of the assets of the SMSF whether immediately or over a period of time.

Related parties

At the centre of this problem is we are dealing with related parties and the definition of a related party requires consideration. A related party of a superannuation fund is defined in section 10(1) of the SIS Act as meaning any of the following:

a. a member of the fund,

b. a standard employer-sponsor of the fund, or

c. a Part 8 associate of a member or a standard employer-sponsor of the fund.

For the most part what we are interested in here is the member and the associates of a member.

Part 8 associates

Part 8 associates of an individual can be summarised as follows:

• a company that is sufficiently influenced by the individual or the individual holds a majority voting interest in. This also includes companies influenced by other Part 8 associates of the individual,

• a partner in partnership with the individual, including the spouse and or children of the partner,

• a trust where the individual (or Part 8 associates of) hold a fixed entitlement to more than 50 per cent of the capital or income, have a sufficient influence or have the ability to remove or appoint the trustee or a majority of the trustees, and

• a relative of the individual defined as a parent, grandparent, brother, sister, uncle, aunt, nephew, niece, lineal descendant or adopted child of that individual or of his or her spouse, the spouse of that individual or of any other individual specified above.

It is the final element that consists of related individuals as identified earlier where problems arise for section 65, but of course it is loans to related entities as is allowed under the in-house asset rules that is creating confusion.

Legal history

As mentioned earlier, there have been a number of court cases that have highlighted the different ways financial accommodation can be made. The following is not an in-depth analysis of each of these cases, but rather a means of identifying how some trustees have been held accountable for their actions.

Coronica and Commissioner of Taxation (Taxation) [2021] AATA 745

Coronica is an interesting case. The above reference is from the initial case that has subsequently led to further hearings largely focusing on an initial decision to disqualify the trustee, which has now been upheld.

At its core, Coronica represents the misguided use of a suspense account to record money owed to the fund by the member and money the fund owed to the member. The amounts were not trivial, nor was there any official documentation supporting the concept of any loan, interest or repayment terms. Ultimately this was one among many facts that led to the fund being deemed non-complying and the trustee disqualified.

It should be noted Mr Coronica was an accountant and tax agent for over 50 years and was found to have created some quite unique interpretations of multiple ATO resources.

WZWK and Commissioner of Taxation (Taxation) [2023] AATA 872

WZWK also involves an accountant who not only lodged SMSF returns, but also audited them. Ultimately the trustee entered into numerous transactions that resulted in him paying himself a non-commutable income stream from age 47, releasing in excess of $800,000 from his fund prior to winding it up. This was done under the guise of a condition of release linked to the cessation of employment, which was demonstrated through the case to have been a carefully crafted arrangement aimed at accessing super benefits early and ultimately providing financial assistance to the member.

Merchant and Commissioner of Taxation [2021] AATA 915

The final case, which has recently been the subject of a decision impact statement being released by the ATO, related to the trustee’s disqualification and subsequent reinstatement and regarded the acquisition of listed shares from a related party. Acquiring shares from a related party is allowable under section 66 of the SIS Act, however, in this instance, the share acquisition was entered into to create a $55 million loss in the member’s family trust, which was used to offset an $85 million gain, the net result being a considerable tax saving to the beneficiary of the trust, who of course was the SMSF member.

So as can be seen, there are many ways to obtain financial assistance other than just taking money out of a fund. The consequences for doing so can be diabolical, just ask Mr Merchant, Mr Coronica and Mr WZWK.