Related Party Loans for Superannuation Funds

Happy New Year!  We hope you have all enjoyed a safe and relaxing holiday period and we are very excited to embark on another year of growth and achievement with each of you.  This month’s Wealth Pipeline looks at circumstances under which superannuation funds can borrow from a related party.

Apologies for an uncharacteristically long edition this month but we preferred not to leave any of  the below out from this summary.  As always, we welcome any questions or comments you might have.

Related Party Loans

It is becoming mainstream knowledge that superannuation funds can borrow under certain circumstances.  However, what is less known is that the relevant legislation does not stipulate where the money can be borrowed from.  As a consequence it is possible for a superannuation fund member or their relative etc to lend money to their fund.  This is particularly effective for acquiring assets that banks are not generally willing to lend for such as equities (shares) and/or if the superannuation fund wants to obtain cheaper funding. 

It is even possible for a superannuation fund to borrow money from both an external and related party to fund the purchase of a single asset.  The domain of borrowing money by superannuation funds to purchase an asset at the instruction of the member is usually the realm of Self Managed Superannuation Funds (SMSFs). 

Some of the Finer Details

• To facilitate a mainstream superannuation borrowing arrangement an additional trust (holding trust) needs to be established to own the asset. 
• Each holding trust can only house a single acquirable asset.
• Borrowed funds cannot be used to improve the asset.
• Non-borrowed funds may be used to improve the asset, but the nature of the asset must not change.
• Particularly relevant when borrowing from a related party; the interest rate charged to the superannuation fund cannot be above what is generally considered commercial.
• An asset owned by a holding trust cannot be partially sold.

What Does this Mean?

• A holding trust may borrow funds from a related party at an interest rate below what is generally considered ‘commercial’.  
• A superannuation fund cannot borrow for say a parcel of shares, for example Rio Tinto, BHP, Westpac, Wesfarmers and CBA under the one arrangement.
• If a superannuation fund wanted to buy both Rio Tinto and BHP shares with a related party loan it would require two holding trusts with separate borrowing arrangements. 
• It is unlikely the cost of borrowing for small parcels of shares would justify the establishment costs.
• If an SMSF seeks equity exposure with borrowed funds, a managed fund, listed investment company or exchange traded fund may be the most viable way to effect this.   

Who Benefits from a Related Party Loan?

Related party loans typically benefit three types of investors:

1)      Those with substantial cash held outside of the SMSF available to lend;

2)      Those with unused equity (generally in property) owned outside of the SMSF.  This can be used to secure a third party loan and ‘on-lend’ to the SMSF; and

3)      Those with insufficient equity and/or saleable assets in their SMSF to support a third party loan.

Advantages

• Simplified loan documentation and reduced upfront costs.
• Third party lenders usually require personal guarantees from the trustees of an SMSF for a LRBA.  Related party loans will usually not require this.
• Funds lent are not subject to a condition of release and therefore not trapped in the SMSF.
• Loan terms are more flexible, e.g. early repayment or changes to repayment cycles should be comparatively easy.
• Amounts well over the superannuation contribution caps can be lent to the SMSF.  Once these funds are invested within the SMSF their earnings and any realised capital gains are taxed at a maximum rate of 15% while in accumulation phase and 0% once in pension phase.

Disadvantages

• Where a related party loan is secured against a non-SMSF asset its equity is unavailable for future use unless the asset/investment generates additional equity or the loan is at least partially repaid.
• Under current legislation the only time an SMSF can leverage against an asset is at the time of its purchase.  Once the loan is repaid the asset cannot be used to secure subsequent borrowings.
• While funds lent by a related party are not subject to a condition of release, the asset purchased with these funds, and its growth are ‘trapped’ for the term of the SMSFs’ accumulation phase.
• Access to non-SMSF funds used in a related party loan will be lost until the loan is refinanced or at least partially repaid.