Peter Townsend of Townsends Business and Corporate Lawyers says that he continually notices a number of mistakes, or poorly developed approaches commonly being made in the borrowing process.
If you want to make the most out of SMSF borrowing, watch out for these 10 traps:
Trap #1 - Failing to Understand Lender’s Requirements
Because SMSF lending is functionally different from ordinary property lending, SMSF advisers and their trustee clients cannot make any assumptions about what lenders are looking for from them.
Carefully check with the lender as to what requirements they have for SMSF limited recourse loans. Remember that banks and brokers are learning just as fast as everyone else is in this area. Trustees should expect closer scrutiny than ordinary property loans because the lender is offering limited recourse terms.
Will the lender require the member to agree to a particular contribution program to ensure sufficient money in the fund to meet any shortfall in income from the property? If so has the trustee considered whether that program will be possible and advisable?
Will the lender require sign off by the fund’s accountant, financial planner and lawyer before proceeding? Will the lender require personal guarantees? Can the members provide guarantees and remain compliant?
Will the bank require that the SMSF trustee and or the holding trustee be companies? Where the fund is buying business real estate from a related party, will the bank expect to see a full contract (arguing s.109 of SIS) rather than simply a transfer document.
Trap #2 – Failing to Appoint an SMSF Loan Champion
SMSF borrowing and purchasing can be complex. We have identified 15 main stages in a typical transaction that have to be successfully negotiated. Each stage in the lending process needs to be handled in the correct sequence.
There are many players who may be involved including (if an arm’s length purchase is being funded) the real estate agent, the vendor, the vendor’s solicitor, the fund’s conveyancing solicitor, the lender, the loan broker, the lender’s solicitor, the fund’s superannuation solicitor, the custodian, the fund’s accountant, the fund’s financial planner and the stamp duties office …twice.
The process needs a champion – someone who drives the process on behalf of the fund and understands all of the issues. An investment/compliance transaction of this kind will go seriously wrong unless someone takes complete control. The property experts will ignore the investment/compliance issues and the investment/compliance experts will ignore the property issues.
Trap #3 – Not Paying the entire Purchase Price from the SMSF
Buying property sometimes requires quick responses and these can be fatal for SMSFs buying and using a loan. The stamp duties legislation in the various states can catch trustees if the good faith deposit is paid from their own pocket and not quickly reimbursed by the SMSF.
All the money must come from the fund or its lender. Further there must be a clear documentary trail showing this to be the case. If you suddenly realise that the purchase has been completed without complying with this rule then seek advice immediately. A solution may be possible but time is of the essence.
Monies provided by the lender pursuant to the loan agreement with the SMSF Trustee are treated as being provided by the SMSF Trustee.
Trap #4 – Not Arranging the Stamping of the Holding Trust Deed
The holding trust deed must be stamped to ensure that any ultimate transfer from the holding trustee to the SMSF trustee attracts only nominal stamp duty. Further it must be stamped within the period allowed for stamping (generally either 2 or 3 months after first execution).
And even though the amount of duty may be nominal, tempting the fund to delay paying that duty, it makes sound, practical sense to have all documents stamped when the people and the financial records relating to the documents are readily available.
The documentary evidence could be very difficult, if not impossible, to find in, say, 10 years time when the loan is being repaid. Double stamp duty could result.
Note that the holding trust deed cannot be stamped until after settlement of the purchase. The duties authorities need confirmation that the settlement money only came from the fund (and its lender) and this confirmation cannot be provided until after settlement.
Trap #5 – The Lender as Holding Trustee
The idea that you can save money by having the lender act as the holding trustee in a related party loan to an SMSF is a fallacy. It will result in a fundamental conflict of interest. SMSF trustees and their advisers don’t need the extra grief of having the ATO questioning if this arrangement is suitable and compliant.
The presence of that conflict (where the holding trustee is both the bare trustee for the fund and the lender to the fund) will undermine the ‘absolute entitlement’ of the SMSF. This in turn could have at least land tax and CGT repercussions for the fund, not to mention undermining SIS compliance. The arrangement should be avoided.
Trap #6 – The Holding Trustee as the Borrower
The SMSF trustee must be the borrower. The parties to the loan contract must be the lender and the SMSF Trustee. The holding trustee on the other hand is the buyer. The sale contract is between the seller and the holding trustee.
If the holding trustee is the borrower, although the provisions of s.67A are avoided (there being no loan to the SMSF) full stamp duty will be payable on any transfer of title from the holding trustee to the SMSF Trustee rather than nominal duty. The very existence of the holding trust may itself be non-compliant in that case.
Trap #7 – The Holding Trustee having active duties
The only function of the holding trustee is to hold legal title to the property while the loan is outstanding, grant the mortgage to the lender and enter into leases of the property.
If the holding trustee has active duties to perform and does not act at the direction of the SMSF trustee then the holding trust may be a GST entity, be required to prepare and lodge tax returns and the ‘look through’ approach from the holding trust to the super fund may not apply for income tax and CGT purposes.
Some of the banks require holding trust deeds to contain active additional requirements on the holding trustee. We do not recommend these and believe in any case that they are unnecessary.
Trap #8 – SMSF Trustee as purchaser – mixing structures
Often we are confronted with an exchanged contract where the SMSF trustee is the buyer. This is a breach of s.67A and must be rectified for the transaction to proceed. Clients should seek advice before they take any step in a limited recourse borrowing.
Most limited recourse borrowing arrangements are structured to take advantage of the “apparent purchaser” or “agency purchaser” duty concessions. If so, the purchaser must be the holding trustee.
One prominent lender requires the holding trustee to be a company it controls. Consequently this lender will require the SMSF Trustee to be the purchaser and special conditions are included in the contract of sale to the effect that the vendor will, on settlement, transfer title to the bank-nominated holding trustee rather than to the SMSF Trustee. This arrangement confers additional control to the lender but does not cause its company to be party to, and possibly entangled complications arising from, the contract of sale.
Generally this structure of a limited recourse borrowing arrangement involves different steps, parties and transactions and, in NSW at least, more stamp duty.
Trap #9 – Out of Date SMSF Trust Deeds
Limited recourse borrowing for super funds is relatively new and dates from September 2007. There was a significant alteration in the law in July 2010. Trust Deeds of SMSFs drafted before September 2007 are unlikely to permit trustees to enter into such arrangements and are unlikely to confer on trustees the relevant powers for such arrangements.
Lenders’ solicitors will review the Trust Deed of SMSFs which are making borrowing applications. If the Trust Deed has not been recently updated, Lenders may require appropriate amendments. While amending a super trust deed is not necessarily an onerous task, typically the SMSF trustee will be told of the need to amend shortly before the intended settlement date. Usually, settlement cannot occur unless and until the amendments are made.
Knowing and understanding the lender’s requirements (such as updating the super trust deed) at the outset of the transaction will permit any necessary amendments to be made without delaying crucial steps of the transaction.
Trap #10 – Related Party Loans that Breach s.109
S.67A does not prohibit the Trustee of the SMSF from borrowing from a related party. However it is important the lending arrangement does not breach other provisions of the SIS Act.
For example s.109 of the Act provides that the Fund and its related parties have to deal with each other so that the terms of the transaction are no more favourable to the other party than those which it is reasonable to expect as if the parties were dealing at arm’s length.
The phrase ‘no more favourable to the other party’ has been considered by the ATO in ID 2010/162 where it says this means “the terms cannot be more favourable to the related party than would have been the case had the parties been dealing at arm’s length, but there is no contravention of s.109 if the terms are more favourable to the SMSF”. There may still however be a contravention of other provisions such as the sole purpose test.
Although these are informal comments by the ATO to the effect that the fund can borrow interest free from a related party, those comments are yet to be finalised as ATO policy. Great care should be taken in relying on these comments.
The calculation of the amount of the interest rate, the term of the loan, the frequency of interest payments, the obligation and timing of principal repayments and the security offered for the loan must all therefore meet the test in s.109. Our advice usually is for the client to ensure that the terms can be obtained elsewhere in the market. Keeping a record of that could prove useful if a suggestion of a breach is made.