The general rule is that your super fund can’t borrow money, although like all rules the ‘no borrowing’ rule has some exceptions. SMSF trustees need to understand the difference between direct borrowing and indirect borrowing and the special rules that apply to each exception.
A relaxation of the super rules in 2007 means that it is possible for a SMSF to indirectly borrow money using long-term loan arrangements to finance super fund investments, including direct property. I explain these special rules later in the article.
Borrowing directly in two scenarios only
Your fund can’t directly borrow money, except in two instances. The two instances where direct borrowing is allowed is when your SMSF needs cash to pay a member’s benefit, or when your SMSF needs cash urgently to settle a share transaction. I explain the mechanics of these exceptions below.
1. Borrow to pay a super benefit
A SMSF can borrow money to pay a benefit to a fund member if the loan satisfies the following conditions:
- SMSF member’s benefit payment is required by law, or by the fund’s trust deed
- SMSF trustee can’t pay the benefit unless the fund can borrow money
- Loan is for no more than 90 days
- Total loan is for no more than 10% of the value of the SMSF’s assets.
A SMSF can also borrow money directly for up to 7 days to settle a share transaction. A super fund trustee can only borrow money to settle a share purchase if:
- At the time the investment was made, it was likely that the borrowing would not be needed.
- The period of the loan is no more than 7 days.
- The total amount borrowed can’t exceed 10% of the fund’s assets.
Note: The super laws also permit the tax commissioner to make written determinations exempting certain share purchase borrowings.
Borrowing indirectly is the latest trend
Your super fund can also indirectly borrow money. A SMSF can invest in managed funds that borrow money (geared managed funds), or even invest in instalment warrants, warrants, options or contracts for differences (CFDs). I write about options and CFDs in the SuperGuide article Guide to SMSF investment rules.
The latest ‘hot’ trend in the SMSF world is the opportunity for a SMSF to indirectly borrow to purchase fund assets, such as residential or commercial property, or listed shares, using a limited recourse borrowing arrangement.
In plain English, such an arrangement enables your fund to purchase an asset using borrowed funds. Your fund makes an initial payment, your fund then pays interest and after a period of time, the fund has the option to eventually repay the full amount and receive full ownership of the asset. At the time pf purchase of the asset, the super fund secures beneficial ownership, but not legal ownership, of the asset.
Note: LRBAs entered into after 30 June 2017 will be counted towards a person’s Total Superannuation Balance (subject to legislation). The outstanding balance of a LRBA will be included in a fund member’s Total Superannuation Balance (TSB). The TSB is relevant because, since 1 July 2017, anyone with a total superannuation balance equal to, or more than, $1.6 million will not be able to make non-concessional contributions, so the federal government doesn’t want Australians using LRBAs to circumvent the contributions rules (for more information about the Total Superannuation Balance rules, see SuperGuide article Non-concessional contributions: 10 facts about the $100,000 cap).
Government’s green light on SMSF borrowing, with conditions
Although indirect borrowing by SMSFs was originally permitted in 2007, the government, and the ATO, have qualified the scope of the borrowing rules, including significant finetuning in 2010, and additional restrictions in 2016 (for more detail on the mechanics of the LRBA rules, see SuperGuide article SMSF borrowing: Investing in property (what’s OK and NOT OK)).
On 20 October 2015, the Liberal government confirmed that SMSF borrowing, through the use of limited recourse borrowing arrangements, continued to remain a legitimate financing option for SMSFs. Note that in April 2016 however, the ATO released guidelines flagging the expected demise of LRBAs financed by related parties, unless the LRBAs were maintained with terms consistent with an arm’s length dealing (and in May 2016, the ATO gave SMSF trustees an extension of time for restructuring LRBAs where the terms of the LRBA were not consistent with an arm’s length dealing).
The government’s green light for SMSF borrowing was announced as part of its response to the Financial System Inquiry (FSI) Final Report. In the FSI final report, publicly released on 7 December 2014, the FSI recommended the removal of the borrowing exception that permits ‘direct borrowing’ using limited recourse borrowing arrangements, but only for any future transactions.
On 20 October 2015, the federal government responded to this recommendation (number 8) in the FSI final report with the following statement: “The Government does not agree with the Inquiry’s recommendation to prohibit limited recourse borrowing arrangements by superannuation funds.
“While the Government notes that there are anecdotal concerns about [LRBAs], at this time the government does not consider the data sufficient to justify policy intervention. The Government will however commission the Council of Financial Regulators and the Australian Taxation Office (ATO) to monitor leverage and risk in the superannuation system and report back to Government after three years.
“The timing allows recent improvements in the ATO data collection to wash through the system. The agencies’ analysis will be used to inform any consideration of whether changes to the borrowing regulations might be appropriate.”
In short, SMSF borrowing remains an option for SMSF trustees.
In April 2016 however, the ATO released guidelines on the terms required for LRBAs that were financed by related parties rather than financed by banks or bank-like organisations. The ATO flagged that unless the LRBA effectively reflected arm’s length dealings, the SMSF trustees involved could expect that any income derived from the asset finance by the LRBA, would be hit with 47% tax (non-arm’s length income), rather than 15% earnings tax. (Note that since July 2017, the rate of tax on non-arm’s length income is now 45%.)
For readers interested in the current and ongoing laws on SMSF borrowing, see SuperGuide article SMSF borrowing: Investing in property (what’s OK and NOT OK). For readers interested specifically in the detailed requirements placed on related party LRBAs, see SuperGuide article SMSF borrowing: Related party LRBAs must be on arm’s length basis.
For those readers interested in why the FSI believed that SMSF borrowing needed to be removed, continue reading.
For those readers interested in how gearing (borrowing) can fit into an investment strategy, see SuperGuide article SMSF investment: Borrowing to invest can be the means, not the end.
Why did the FSI recommend banning SMSF borrowing?
In its final report, released in December 2014, the FSI used the term ‘direct borrowing’ to describe “any arrangement that funds enter into where the borrowing is used to purchase assets directly for the fund”, even though a limited recourse borrowing arrangement (LRBA) uses an interposed trust to manage the ownership and borrowing arrangement.
According to page 86 of the FSI report, the rationale for recommending the ban on SMSF borrowing was to prevent unnecessary build-up of risk in the superannuation system, and to ensure that the objective of superannuation is to be a savings vehicle rather than a broader wealth management vehicle.
The report continued to explain that “borrowing, even with LRBAs, magnifies the gains and losses from fluctuations in the prices of assets held in funds and increases the probability of large losses within a fund.”
Although I don’t disagree with this description of the risks of borrowing, I would argue that options, warrants and contracts for difference can also magnify the gains and losses of investments, and I question whether all geared-like products should be considered under this review umbrella rather than just one type of borrowing. The FSI may also consider the role of mortgage funds and other geared-style products when reviewing the risks of ‘borrowing’.
I believe the reasons for pushing for a ban on SMSF borrowing are weakly argued in the FSI report, although that is not to say that the underlying policy position of banning borrowing is a weak position. The Reserve Bank of Australia and the key regulator of large super funds, APRA, also supports the review of the borrowing exception.
I do lose patience however when I see sweeping statements accusing fund members of breaking the rules (with no evidence to back it up) such as: “Borrowing by superannuation funds also allows members to circumvent contribution caps and accrue larger assets in the superannuation system in the long run”.
Note: The Government has rejected the FSI’s recommendation, and SMSF borrowing continues to be available.
See below for more SuperGuide articles explaining the rules surrounding SMSFs and property, and also SMSF borrowing
The following SuperGuide articles provide more guidance on what SMSFs can and cannot do in relation to property investment and/or borrowing:
- Revisited: Is property a good investment for your SMSF?
- SMSFs for Beginners: Can my DIY super fund borrow money?
- SMSF investment: Borrowing to invest is a means, not an end
- SMSF borrowing: Investing in property (what’s OK and NOT OK)
- Property and super: What’s the deal? (15 popular Q & As)
For recent ATO guidance on LRBAs financed by related parties, rather than banks or other financial organisations, see ATO links below:
- PCG 2016/5: Income tax – arm’s length terms for Limited Recourse Borrowing Arrangements established by self managed superannuation funds
- ATO ID 2015/27 (Superannuation): Income tax: non-arm’s length income – related party non-commercial limited recourse borrowing arrangement to acquire listed shares
- ATO ID 2015/28 (Superannuation): Income tax: non arm’s length income – related party non-commercial limited recourse borrowing arrangement to acquire real property