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SMSF borrowing

While regulated super fund trustees are now enjoying the right to borrow, we all know that trustees cannot borrow as easily as individuals might borrow.

One of the important requirements to meet is to ensure the loan is a limited recourse loan: where the lender rights against default by the super fund trustee on the borrowing (or on its sum and total charges) are limited to rights relating to the asset being acquired.

As a result, lenders bear more risk than usual. To help defray the extra risk, they may charge higher than normal interest rates. In other words, trustees pay a risk premium on borrowings, typically an interest rate that is 1–3% higher than the going rate.

Bank practice usually requires related parties to give personal guarantees for borrowings and SMSF borrowings are no exception. Many banks have been asking members of SMSFs to give personal guarantees and the ATO has flagged related party guarantees as a cause for concern.

A high-value solution

You can borrow personally, giving personal guarantees. In this case, the loan is not subject to any superannuation borrowing restrictions and the interest on this loan is the normal interest rate.

You can then on-lend the money to your SMSF. The interest on this loan is the normal interest rate plus the risk premium. Because you control the loan, you can choose not to require related party guarantees. If related parties lend to their SMSF, the interest rate must be at the ‘‘commercial rate of interest.’

Complying with these requirements provides an important arbitrage opportunity. You can borrow at, say, 9% and on lend to the SMSF at, say, 10.5%. By using related party lending, the risk premium stays within the family group. It is this risk premium that adds tremendous value.

This is a beneficial arrangement. Compliance is often looked upon as a cost and not a source of profit; in this case, you could see significant returns simply by following the requirements.

Case study

Trustees of an SMSF with $1million cash resolve to buy business real estate worth $2million and seek to borrow the balance of the money to acquire the asset. The fund’s investment strategy and governing rules expressly allow for such an arrangement. Either the fund borrows directly from a bank or borrows from its individual trustees.

In the first instance, the fund will pay an effective interest rate of 10.90%, and the trustees will be required to give personal guarantees. However, in the second instance, the fund borrows from its trustees. The fund pays an effective interest rate of 10.90%. The trustees will borrow from the bank and will personally pay only 9.26% interest. The difference, 1.64% on the amount borrowed, represents real profit for the trustees while the fund benefits from the acquisition of the asset.

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