A Self-Managed Super Fund (SMSF) can invest in many different types of investments, including loans. For example, a secured loan to a business or a loan to a property developer.

Loans are generally considered a high-risk investment from a compliance point of view because of the relationship that may exist between the fund and the borrower. Where there is a close relationship between the fund and the borrower, there is an increased risk that the loan is not made or maintained on commercial terms.

The most common audit issues for SMSF loan investments are: 

1. No evidence to support the market value.

2. No evidence to support the loan terms are commercial.

3. Trustees not enforcing the terms in the loan agreement.

How to support the market value for loan investments?

The market value of the loan is determined by its recoverability and supported by evidence of the ability of the borrower to repay the loan such as:

• Evidence of repayment of the loan post year end

• Evidence of the financial position of the borrower confirming their ability to repay (e.g. a copy of the financial statements if the borrower is an entity)

• Evidence of the market value, existence and ownership of any assets held as security for the loan.

The loan agreement and evidence of interest repayments demonstrate that the loan exists. It does not provide evidence of the borrower’s ability to repay the loan.  If insufficient evidence is provided to support the market value of the loan, the auditor is required to qualify both the financial (Part A) and compliance (Part B) section of the audit report.

It can be tricky for trustees to prove the loan is recoverable and recorded at the appropriate market value. Especially where the borrower is an individual and the loan is unsecured.

Example 1

Tim’s SMSF has made a $400k loan to a company owned by his friend Fred, a property developer. The loan agreement lists Fred’s investment property, worth $1.5m, as security. The financial statements of Fred’s company show the loan at $400k on the balance sheet, which aligns with the SMSF financials. The auditor obtains a title search for Fred’s investment property, which confirms there is a registered charge against the property by Tim’s SMSF. 

In this scenario the auditor would normally accept the loan is valued correctly. If Fred were to default on the loan, Tim would be able to take possession of Fred’s property and recover his loan investment. If on the other hand, Tim’s SMSF hadn’t registered a charge over the property, the auditor would probably qualify the audit.

Even if Fred’s company had positive net assets, the auditor may still qualify the audit when a loan is unsecured as it may be difficult for the SMSF trustees to take possession of any company assets.

What about Personal Guarantees?

Personal Guarantees from the borrower might make the lender feel better about the recoverability of the loan. Unfortunately, they are not very useful for the SMSF auditor as it is tricky for anyone to attribute a value to a personal guarantee.

It would generally be difficult for the auditor to get an accurate and reliable picture of all assets and liabilities any individual may have.

How to support the loan terms are commercial?

Trustees should provide information on how the terms of the loan agreement were determined. It is not up to the auditor to determine if the interest rate is appropriate.

Especially where the loan is provided to a related party, the trustees need to document how they have determined that the loan terms are commercial. This could be done by providing evidence of the terms used by commercial lenders for similar loans and benchmarking the terms in the loan agreement against those of a commercial lender.

In terms of the interest payments, it is unlikely for a commercial lender to provide finance and accept payment of interest only upon maturity of the loan. Monthly interest payments would generally be expected.

Example 2

Tim’s SMSF has made a $400k loan to company owned by his friend Fred, a property developer. The loan is secured against a property. Tim’s SMSF charges Fred’s company 8% per annum in interest which is paid monthly. Tim has provided the auditor with evidence of the interest rate charged by 3 commercial lenders for similar secured business loans. He has used the average figure to determine the rate charged to Fred’s company.

In this scenario, the auditor would normally accept the interest rate is on an arms-length basis. The auditor will also review the other terms of the loan to determine if all other aspects of the agreement are on commercial terms.

Enforcing the terms of the loan agreement

Just having a loan agreement that says all the right things is not enough. The trustees also need to enforce the terms of the loan agreement. This means seeking payment when due and varying the terms of the loan agreement when they are renegotiated. If the trustees are not enforcing the loan terms, the auditor may need to report a breach of the arms-length rules (S109).

Other compliance considerations

Keep in mind that SMSF’s are never allowed to loan monies or provide financial assistance to members or relatives. When an SMSF makes a loan to another entity or individual, the loan agreement will specify the terms and conditions of the loan, including whether the loan is secured or unsecured. Generally, the auditor will also require information regarding the borrower such as their business activities and the purpose of the loan.

One of the benefits of having an SMSF is the wide range of investments trustees can invest in. But make sure you are aware of the different compliance considerations and audit requirements before making a new investment.

How can Red Willow Super help you?

We would love to help you, whether it is with completing SMSF audits, providing compliance support or delivering technical SMSF training.

Our team has extensive experience which means we can assist with a range of SMSF issues. We have assisted many accountants, advisors and trustees with compliance issues. Let us be your competitive advantage.

Want to find out more? Check out our website, call us on 1300 920 2230 or email Support@RedWillowSuper.com.au

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