How to avoid an SMSF tax penalty

The Australian Tax Office (ATO) has recently changed the way it assesses income earned by assets paid for by a Self Managed Super Fund (SMSF) borrowings. In some cases, income earned by assets in this category will be treated as non-arm’s length and won’t qualify for the tax concessions available within super. Instead, these assets may pay tax at a rate equal to the top marginal tax rate, currently 47%.

Let’s say an SMSF borrows funds to buy an investment property and the borrowing arrangement is deemed to be one where the non-arm’s length income rules apply. The rental income from the property would be taxed at 47%, rather than the 15% tax rate that applies to SMSF income for accumulation accounts, or the 0% tax rate that applies when rental income supports a pension paid by the fund.

It’s important to note that the ATO will only apply these rules in a very limited number of cases where it has concerns about related party borrowings. It has said there’s nothing wrong with a related party providing the funding for a SMSF’s borrowing. The loan could be provided by a member of the fund, a relation of a member or any company or trust controlled by the family.

However, the ATO has said it has concerns about three facets of some related party loans where the SMSF and the lender don’t deal with each other as if unrelated:

  1. The first issue occurs when related party lenders charge the SMSF artificially low or no interest to increase the benefits retained in the SMSF and maximise the income earned by the asset. For example, if a member loans funds to their SMSF, which uses them to acquire a property, the SMSF pays the member interest from the rental income. The member is obliged to declare the income in their tax return and pay tax on it at their marginal tax rate. But if they don’t charge interest the member won’t have income from the loan to declare for tax purposes. The ATO says this is a “scheme” and lenders should always charge a commercial rate of interest.
  2. The second issue relates to lenders who provide nearly all the funds to buy the asset. SMSF loans are limited recourse in nature, so in the event of a default the lender can only take possession of the asset acquired with the borrowed funds. The ATO says when the lender provides most of the funds to buy the asset it should seek mechanisms to recover its funds such as guarantees from members using non-superannuation assets.
  3. The final issue is the regularity of payments. Some loans have been set up with a single repayment of the loan at maturity, up to 20 years in the future. The ATO says this situation would be unlikely if the lender and borrower weren’t related and prefers to see regular repayments.

Borrowing within SMSFs can be an effective, although complex strategy. There can be serious consequences such as higher tax payments if mistakes are made and it’s essential to seek professional advice from your financial adviser before borrowing to buy an asset within a super fund.