Securing assets of an SMSF for the short term
You see a property that you want in your SMSF but there’s no time to arrange a bank loan before you must finalise the purchase or miss the property. Let’s lend the money ourselves and then refinance shortly thereafter.
Due to loan application and loan processing time constraints, Gary and Debra want to acquire a property through their SMSF via a limited recourse borrowing arrangement using a related party loan and then, straight after settlement, they want to refinance the related party loan with a commercial lender. They want to know whether there will be any implications in doing so.
Issue 1: Arm’s Length Dealing
The ATO has released Practical Compliance Guidelines (PCG 2016/5) which set out safe harbour terms on which SMSF Trustees may structure their related party loans so that a related party loan is consistent with an arm’s length dealing.
The ATO accepts that a related party loan is consistent with an arm’s length dealing where an LRBA has been used to acquire real property, or to refinance a borrowing used to acquire real property if a mortgage has been registered over the acquired property.
For an SMSF to meet the ATO’s Practice Compliance Guidelines it is recommended that a mortgage is registered over the acquired property soon after settlement has occurred.
In Gary and Debra’s scenario they wish to refinance the related party loan shortly after settlement. From a practical perspective it may be costly and time-consuming for Gary and Debra to register a mortgage over the acquired property between the mortgagor (holding trustee) and the mortgagee (related party lender) only to then have to discharge that mortgage for the commercial lender to secure and register its interest in the property on title.
However, the trustees/directors of an SMSF must satisfy the statutory covenants contained in Part 6 of the Superannuation Industry (Supervision) Act 1993 (Cth) (‘SIS Act’). Exactly how short a time would be considered acceptable to the ATO for the purposes of avoiding the (unnecessary) expense of having to register the first mortgage cannot be stated clearly. But certainly the time would be measured in weeks not months.
One answer may be to register a caveat against the title rather than the actual mortgage as the registration of a caveat is slightly easier and less complicated. The question will remain whether a caveat provides sufficient security in the circumstances (including the relatively short time until completion of the refinance) to comply with the trustees/directors duties.
Issue 2: Trustee Statutory Covenants
Part 6 of the SIS Act provides statutory covenants that trustees/directors of an SMSF are required to follow when performing their duties. A contravention of a statutory covenant may result in civil and/or criminal consequences.
These covenants include trustee’s exercising their power in the best interests of beneficiaries and extends to trustees securing trust assets of the SMSF.
In the context of a limited recourse borrowing arrangement the trustees/directors of an SMSF must ensure that if a default on the loan occurs that the lender will only have access to the individual property which secures the loan and not to any other property also held on trust for the SMSF by the holding trustee.
Failing to register the mortgage securing the related party loan may constitute a breach of this statutory covenant by the fund trustee.
Again the registration of a caveat may be the answer to cover the short period until the refinance.
Issue 3: Document the first transaction
As Gary and Debra wish to refinance the related party loan with a commercial lender shortly after settlement they may believe the original loan from them is only a short-term step and therefore no documentation of that loan is necessary. This is a big mistake.
It is vital that resolutions of the SMSF Trustee, the holding trustee and the related party lender be prepared and kept on the Fund’s register as evidentiary documentation should a third party query a mortgage not being registered between the holding trustee as mortgagor and the related party as mortgagee.
These resolutions should be prepared to formally record the SMSF Trustee directing the holding trustee to enter into a loan refinance and for all parties to acknowledge that the existing loan is to be refinanced with the commercial lender.
To see how we can assist with preparing such documentation or for further information, please contact Townsends Business & Corporate Lawyers on (02) 8296 6222 or email firstname.lastname@example.org.