Normally self-managed superannuation funds (SMSFs) are prohibited from borrowing money or maintaining an existing borrowing of money. A limited exception to this, since 2007, is the limited recourse borrowing arrangement (better known as “instalment warrants”).
Capitalisation of interest
There has been some issue, in the past, over whether a capitalisation of interest causes SMSF instalment warrants to breach the no borrowing rule.
Capitalisation of interest occurs where the borrower may substitute, for the payment of interest on the borrowed amount, the mere drawdown of a further loan from the same lender. The further amount which must be repaid substitutes for the interest.
ATO’s approach to capitalisation
In the past the ATO has stated that capitalisation in this manner would breach the no borrowing rule, or that capitalisation is only permitted where the loan is a commercial-style product.
However, recently the ATO (following Government amendments to legislation) has stated that:
- it remains true that each drawdown under a capitalised loan constitutes a new borrowing by the SMSF; and
- despite this, these new loans will comply with SMSF law so long as the drawdowns are solely connected to the original borrowing and nothing else.
(Note that all the other instalment warrant rules must also be met, for instance recourse of the lender must remain limited to the originally acquired asset).
Example: Capitalisation of interest
B and C, who are members and individual trustees of a certain SMSF, determine that their SMSF will invest in a property located in Geelong VIC. However, the SMSF lacks the funds to acquire this investment without financing.
The SMSF applies to X Co, a bank, for a loan to acquire the Geelong property. The SMSF enters into the following arrangement:
- the SMSF sets up a bare trust;
- X Co lends the amount to the SMSF to acquire the property;
- the bare trust actually holds the property, with the SMSF as the sole beneficiary;
- X Co’s recourse is limited to the property itself; and
- the SMSF will acquire legal title to the property upon making six payments including interest.
B and C also owe money to X Co on their own account, for the acquisition of a tractor for their farm. They have been having great trouble keeping up with payments for the tractor.
B and C as SMSF trustees determine that the SMSF wishes to capitalise the interest on its loan, since this would be financially the better course. However, X Co is tired of B and C’s continued inability to repay their own tractor loan.
X Co therefore permits the SMSF to capitalise its loan by drawing down more from X Co. However, X Co demands that the SMSF draw down a larger amount than usual, to make up for the late payments on B and C’s tractor loan.
In this case, the original arrangement would appear to satisfy the requirements for SMSF instalment warrants.
However, the proposed capitalisation would be in breach of the no borrowing rule for the SMSF. The capitalisation of interest is permitted, but must relate solely to loan for the original asset held by the bare trust. It cannot relate to any other loan.
If you have concerns over your SMSF and the capitalisation of interest, call LAC Lawyers and we can provide advice and assistance.