SMSFs engaged in property development via a unit trust structure should avoid cheap sources of funding as they likely will lead to breaches of the non-arm’s-length income (NALI) rules, according to a taxation lawyer.
AG Tax Lawyers director Andrea Carrick said using unit trusts for property development allows SMSFs to join with other funds to borrow money without using limited recourse borrowing arrangements and conduct a business, but problems occur when drawing on low-interest finance.
“In this scenario we don’t have to be mindful of balance sheet restrictions that apply with a related-party trust, but where it goes wrong is because of the cheap finance option,” Carrick said at the recent The Auditors Institute SMSF Auditors Day in Melbourne.
“This is where the SMSF trustees or members say they don’t want to pay interest to a bank on, say, $3 million and want to get the cost down to get the net profit up for our super funds.
“They will suggest their family trust lends $2 million and the SMSF will borrow $1 million from the bank, so the unit trust will still have a mortgage, but the family trust will lend interest free and they can save interest on $2 million.”
She said this was not an uncommon scenario, which resulted from people not understanding the relationship between the SMSF, unit trust and family trust when engaging in property development.
“The problem with cheap finance is now the unit trust is engaging with a party on non-arm’s-length terms and it’s got an interest-free loan coming in,” she said.
“The SMSF may have done the right things in terms of the investment and paying the bank at the right rate, but the family trust is not getting any interest on their investment as the unit trust is paying less than what it should be and generating more net income.
“When the net profits eventually come out to the super funds, we’ve got NALI because of this cheap, interest-free loan in the trust that’s going to taint the net income and even the capital gains or the profits from sale.
“So they have stuffed it because they thought they could do it cheaper, but have actually generated a 45 per cent tax bill on the profits instead and shot themselves in the foot.
“I should also point out this is a problem even before the non-arm’s-length expenditure (NALE) rules apply. This is just straight up NALI and we don’t even get to the NALE territory in that scenario.”
