SMSF Made Non-Complying: 7 Lessons From the Case

24 July 2009

A SMSF which lent considerably more than 5% of its assets to a related company has had its loss of compliance status confirmed by the Administrative Appeals Tribunal.

The SMSF was operated by a husband and wife business team.  Due to difficult trading conditions, ill-health and natural disasters, the husband and wife were confronted with either allowing their business company to go into administration or to obtain “emergency” finance from their SMSF.  They chose the latter. 

The loan was initially to be $130,000 (itself in excess of the maximum related party investment limit of 5% of the value of the SMSF) for a 5 year loan period with interest at 10%.  However, due to various borrowings, the loan principal peaked at $211,000.  At one stage the loan amounted to almost 95% of the value of the SMSF.

The loan first breached the 5% limit during the 2004/05 financial year and the breach continued until 2008/09 financial year.  The breach was not reported to the ATO until the July 2007 but the trustees did not make a serious attempt to rectify the breach (ie reduce the loan amount to below 5%) until early 2009.  In the meantime, they had sold other properties and used the sale proceeds in other investments.

Simply breaching the 5% related party limit does not make the SMSF non-complying.  Breaching this limit causes the ATO to consider whether the SMSF should have its compliance status cancelled. 

The following lessons can be taken from this case:

  • Don’t breach the 5% limit
  • If there is a breach – notify the ATO and rectify the breach (ie repay the loan) as soon as possible
  • Reasonable interest must be paid on the loan amount
  • If the ATO offers an enforceable undertaking in relation to any rectification – treat the offer with utmost respect
  • If an enforceable undertaking is accepted – honour the undertaking
  • While illness and natural disasters are relevant factors (favouring the retention of compliance status) the husband and wife during the breach period did sell other assets and could have used the sale proceeds to reduce the loans but decided not to do so
  • Arguing that the related party loan was a better investment than the share market will not get you very far (even if it was the case).

The case is reported as JNVQ v Commissioner of Taxation [2009] AATA 522 and was handed down on 14 July 2009.

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