ATO attempt to close a contributions loophole

Integrity measures in the form of contribution caps are limits on how much a member can contribute to an SMSF. They are intended to limit the amount of tax benefits anyone can get out of using a SMSF.

Prior to 2007 the Reasonable Benefit Limits (“RBLs”) enabled a member to put as much into a SMSF as they wanted although not all of it would be tax-deductible. If the member took out more than was considered reasonable, they paid extra tax. From 2007, the tax system reverted to placing limits on the amount that could be contributed to a SMSF.

However, the effect of the integrity measures could be significantly lessened if, instead of contributing to a SMSF and being limited by the contribution caps, a member could lend a significant proportion of their wealth to the SMSF interest-free. Further, being both the borrower (as a member of the SMSF) and the lender, some members were choosing not to pay themselves interest, thereby retaining more of the funds in the SMSF as well as not generating personal income on which they would pay tax at their marginal rates.

The ATO regards this as a serious integrity breach and has been trying to resolve it. The approach to be taken is to reclassify any income that the SMSF receives from an investment it acquires with the funds that have been borrowed at zero interest from the member. This will be classified as “Non Arm’s Length Income” (NALI). This type of income is taxed at the highest marginal tax rate and not the preferential super tax rates of 15% (or 0% if in pension mode).

With this new attempt to tackle this issue the ATO has now put the SMSF market on notice of the risk of tax at 47% on related party non-commercial loans. The initial response from the SMSF advising market is to advsie that all loans to SMSFs, including from related parties, should be on full commercial terms. This is not only with respect to the interest charged, but also in terms of LVRs and payment schedules.