Don't crap in your SMSF

Earlier this week I was reading the following article (which is excellent advice) warning people about getting too carried away at the prospect of making no/low interest loans to their SMSF. It made me think of a saying an old colleague used incessantly: 'You don't crap in your OBU'.

The saying isn't the most elegant, and 99 per cent of people probably don't know what an OBU is, but the point is important to those running SMSFs. To explain, let me first digress.

For the benefit of those not in the lucky 1 per cent familiar with OBUs, or 'offshore banking units', it is a special tax concession granted to Australian banks. The provisions allow them to allocate the income from certain foreign banking activities to their OBU and only pay 10pc tax. The principle was to allow Australian banks compete more effectively for overseas business.

Paying 10 per cent tax is, of course, a whole lot better than paying 30 per cent tax. Non-bank taxpayers would love something similar.

Hence my colleague's point. When you're on a good wicket you want to think long and hard about pushing the envelope. Why? Because the downside's a whole lot worse than the upside from playing games. In this case a bank would be risking the loss of their OBU status by 'putting crap in it'. As a result, it makes good sense for banks to be more cautious with their OBU than they might be otherwise.

The same point applies to SMSFs and, in particular, the low/no interest related party loan strategies currently doing the rounds.

The idea is simple. If a related party lends, interest free, income that would have been earned by the related party is now earned by the SMSF (15pc rather than 30pc-46.5pc). Plus the 'gift' being made by the related party increases the capital of the SMSF without having to make a contribution (which would be capped). Best of all, the ATO has (supposedly) approved this strategy.

What the ATO actually did was give a favourable response, in a quarterly catch up with technical boffins, to a couple of technical points related to this strategy (it doesn't breach the arms length provisions of the SIS Act, nor is the gift to be regarded as a contribution). These comments aren't binding on them. Plus they didn't comment on whether other anti-avoidance provisions (and their penalties) might apply, or whether they might look to other potential breaches of the SIS Act (with the threat of 'non complying fund' status).

The point of Hall and Wilcox (authors of the article above) is simply that they think the Cooper Review will see the practice prohibited. This may not result in penalties for past behaviour but it can be a disastrous outcome for someone whose investment strategy relies on the loan being in place.

But the biggest problem this particular strategy has is the amount of publicity it's getting. A cheeky tax game, in an arena which already gets a lot of scrutiny, does not have good odds for survival. The question is whether it swill simply be shut down or a witch hunt commenced.

None of this means this particular strategy is to be avoided at all costs. Everyone has a different risk tolerance and some may be comfortable they've got a 'best of breed' version of the strategy or, at least, have mitigated their downside exposure. But conservative investors should think twice.

Remember, an SMSF is not like an individual, or company. Individuals don't risk getting put on a higher tax rate for being naughty. An SMSF, with it's special tax status, is different. So the lesson, for the conservative investor, is 'don't crap in your SMSF'. Maximise your benefits by doing all the simple stuff right (for instance, maximising contributions, picking the right assets and minimising fees). But, unless you're happy to risk back-tax, penalties, the complying status of your fund and protracted fights with the ATO, avoid pushing the envelope.