Related Party Loans / Lending to a Trust

The ATO a year or so back issued a ruling for SMSFs on related party loans that should not be confused as being fully relevant for other related party loans and dealings. SMSF laws are very strict in terms of related party loans and the ability to breach sole purpose tests and other elements of super laws and can even be used to implement schemes with benefits. That is however a SMSF issue. Its important to distinguish between a SMSF and general trusts.

Generally trusts can borrow money from related parties or anyone else if they wish to lend and whether it is a interest bearing loan or a "at call" loan or some other form of indebtedness the key issue that arises during tax review. When we refer to a loan here we are referring to the position where the entity has borrowed / obtained funds and not when it lends (outward) funds. Lending of funds by the entity may fall foul of other law eg Div 7A and other provisions.

Several key issues are generally evident when the ATO has reason to review a entity and loans are noted:
- The loan is a element of a scheme and a scheme benefit is argued
- The loan is said to be at call with unexplained debits and credits
- The loan is said to be on terms which are not evident or agreed between parties.
- The loan does not appear to be settled for the said purpose
- The loan is forgiven, written off or statute barred
all of which may or may not be a concern. And f
- The loan appears documented, settled and maintained - A good position.

The issues and risks with poorly documented and undocumented "loans" of any form tend to also combine one or more than one of the above key issues. eg a loan is at a rate which appears to produce a deduction which is an element of an apparent scheme benefit and is poorly documented.

The ATO generally adopts the view that a loan is a contract and two parties are free to contract on the terms that they agree provided that it does not produce a scheme benefit or produce any other form of concern eg capitalising, forgiven etc. However not all well documented loans are acceptable. Many schemes rely on complex loan arrangements which are well documented using legal expertise to draft aspects of a scheme.

And one of the most fatal forms of loan is one which commences on apparent arms length terms and is well documented and which later becomes poorly maintained so that the terms of the loan are not complied with. Often due to financial necessity and impending concern these loans typically capitalise or cease to be paid and maintained. That can render previously accrued or paid interest to be at risk perhaps even the loan proceeds held to be income.

The ATO will often allege in a tax dispute that inflows of funds described as loans are income unless they are correctly documented and thereafter maintained as loans. In many family discretionary trusts related parties like the trustee directors consider "their" funds being credited to the trust as a simple loan at call. However the trust does not retain minutes / resolutions of such borrowings or their source. The ATO then seeks to understand whether the sum credited to the bank account is income and asks for evidence of the source and nature of the funds. Often that can be absent or long forgotten (eg proceeds from Grandma's deceased estate). My tip is that all movements to a related loan should be supported and sufficient evidence retained to avoid that concern in 5, 10 or more years.

So all loans should be:
1. Well documented for their terms;
2. Well maintained to the agreement and consistent with advice;
3. Accounted for consistently in the financials;
4. Supported by valid legal and tax advice;
5. Documentation for sources of funds should be retained permanently;
6. Revised legal / tax advice obtained if any matter affects the loan being maintained.

In many instances the ATO may enquire about loan security and legal advice specific to this issue will vary with each situation. However just as loan security is not relevant to claiming deductions for your IP (eg you can use your home as the security) then the ATO may also not have concerns for a unsecured loan received by a trust which satisfies other elements that confirm the loan - Is a loan.

 

Good write up Paul.

I often see loans in place which may require monthly repayments - yet no repayments are ever made...

 

Its just like a Hybrid Trust. They arent dodgy or a problem IF the taxpayer operates it within the scope of the tax ruling/s

How you operate is often more important than the structure and it may contrdict the structure or even bypass it !! Setup a trust and do it badly and its not a trust. I have seen people choose to not open a trust bank account then argue that funds were loaned to a trust yet there is no tangible evidence of the loan to the trust. Or unit trusts where no paperwork is completed., no units issued, no registers of unitholders and no bank account.

 

I see many people that think signing a trust deed, without even reading it, is a magical bullet proof protection for asset protection - yet there is often no protection at all with how they have set it up.

So deeds and contracts are only half the story, it is how the transactions are operated that makes the rest.