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Self Managed Super Fund (SMSF) Article
SMSFs and Promissory Notes

By Tony Negline.

This article may be out of date.

2nd June 2004

Psst.  Unsuspecting trustees be careful.  A relatively new and nifty Self Managed Super Fund strategy is being paraded around the traps which just might get all concerned into deep trouble.

The strategy involves the SMSF paying a member a benefit using a promissory note.

The Oxford English Dictionary defines a promissory note as “a signed document containing a written promise to pay a stated sum to a specified person or bearer at a specified date or on demand”.  In simple terms a promissory note is the legal form of an “IOU”.

The following points are reasonably typical of this strategy:

• The SMSF has an asset which makes up the majority of its total assets (for example property)
• A member, who has the majority of assets in the fund – or all the assets, if we are dealing with a single member SMSF – is permitted, by the preservation rules, to take a lump sum from the fund
• The fund wants to pay a lump sum benefit to a member so that the member, or their spouse, can then re-contribute the withdrawn amount back into the fund to make future pension payments more tax effective.  This segment of the strategy, commonly referred to as “withdraw and re-contribute”, is extremely popular at the moment across many super funds but not without in its own potential problems (but this is a story for another day)
• Whilst withdrawing and re-contributing into the SMSF makes sense to the member, in order to pay the lump sum benefit, the SMSF trustee would need to sell the big asset which would generate significant costs such as stamp duty and capital gains tax
• To solve these problems a promissory note (PN) is used to make the benefit payment.  In effect the trustees “pay” a benefit to the member by issuing the PN to the member.  The member, or their spouse, at some later stage might then endorse the PN back into the fund as a contribution.  Although it is accepted that the PN can be enforced, it is generally accepted between the parties that a demand for payment will never be made.

At the moment many SMSF professionals are divided as to the validity of these transactions.

Some are actively promoting this strategy and helping their clients implement it.

Others argue that there is a range of problems.  Head of Zurich’s Technical Services, Sam Wall, on balance believes the strategy is too controversial and suggests that SMSF trustees and members should find another way to achieve their retirement income objectives.

“This whole strategy is basically borne out of trustees wanting to have their cake and eating it too.  There is nothing wrong with trustees wanting to maximise the benefits in their super fund.  This is one of their major jobs but sometimes people can push the rules too far,” he said.

“By using this promissory note strategy, the trustees want to have a SMSF with a lumpy asset.  They want to maximise their retirement income by withdrawing and re-contributing.  But they also want to avoid any costs in achieving their objectives,” said Wall.  At the very least this raises an Investment Strategy issue, he concluded.

Scott Charaneka, super partner at Deacons Lawyers believes that under the tax laws a benefit might not be paid from the fund when the PN is issued.  “Under the tax laws a super fund will only have paid a benefit if money leaves the fund.  In normal circumstances when a fund pays any benefit it must report certain information to the Australian Taxation Office for Reasonable Benefit Limit purposes.  If a benefit hasn’t been paid then nothing can be reported,” he said.

Gary Riordan and Robert O’Donohue of Melbourne based super lawyers, Holding Redlich, argue that when the PN is contributed back into the fund then it might be a prohibited acquisition of an asset from the member.  “Trustees are only able to acquire certain types of assets from members and their related parties,” they said.  “One of those assets is money we are not convinced a promissory note would fall into this category.

Wall, Charaneka, Riordan and O’Donohue all agree that the income tax anti-avoidance provisions might be applied to the transaction.  “If the ATO did apply the anti-avoidance provisions to this transaction then the penalties might be very severe,” said Wall

Consequently they all said that any trustee who wishes to enter into this type of arrangement should seriously consider getting a binding ruling from the ATO on the tax aspects of the transaction.

A spokesman for the ATO told The Australian that they are aware of this transaction and may be releasing some information about it at some other stage.

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