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Self Managed Super Fund (SMSF) Article
Prommissory Notes

By Tony Negline.

This article may be out of date.

30th July 2008

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A strategy which reappears from time to time involves a Self Managed Super Fund 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 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 Self Managed Super Funds 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.  Sam Wall, Head of Colonial First State Investment's Technical Services, says that on balance the strategy is too controversial and suggests that Self Managed Super Fund 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 eat 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 Self Managed Super Fund 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.

In May 2004 – long before Peter Costello announced his Better Super changes – the tax office released material on their website that said a super fund could "probably" pay a benefit using a promissory note.  "Promissory notes have an assigned monetary value and are convertible to cash," the ATO said.

However 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 any event the purpose behind using a Promissory Note is to avoid having to sell an asset not to enforce the PN's underlying value as cash.

Gary Riordan, Group General Counsel of Australian Wealth Management Ltd argues 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."

A recent draft ATO ruling on accepting contributions says that a Self Managed Super Fund can accept Promissory Notes as contributions if the PN is not a commodity and is a medium of exchange.  A PN will be a commodity when it is an object of exchange and "is traded on secondary markets or is issued by one entity (the maker) to another entity (the payee or bearer) at a discount from face value with the face value payable to the payee or bearer upon maturity. The acquisition of such a promissory note is an acquisition of an asset other than money."

If we assume that a PN is an acceptable contribution then it will be counted towards a contribution limit.  Once the relevant limit is exceeded then penalty tax will be payable.  Also when the PN is used to pay the benefit, depending on the taxpayer's age, if the Taxable Component exceeds the maximum allowed ($140,000 in 2007/08) lump sum tax may be payable.

Wall, Charaneka and Riordan 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.

Typical Steps in a Promissory Note 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”
  • 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

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