Promissory notes not so promising

On May 18, 2009, the Australian Taxation Office (ATO) issued a Taxpayer Alert TA 2009/10 regarding the non-commercial use of negotiable instruments through self-managed superannuation funds (SMSFs). Generally, these arrangements would involve the use of promissory notes, but could also involve the use of cheques.

It is important to understand that a Taxpayer Alert does not change existing law, rules or regulations. Rather, it is to put people on notice that the ATO has identified a particular issue that could potentially be in breach of the law (or the spirit of the law) and that it will generally be subject to a greater level of scrutiny by the ATO.

The issue

Whilst not ruling out the use of promissory notes in appropriate circumstances, the ATO is concerned about arrangements that involve a trustee or member issuing a promissory note, cheque or other negotiable instrument with no exchange of assets taking place, or the exchange being delayed intentionally.

According to the alert, such transactions may include:

• a trustee of a self-managed superannuation fund (SMSF) giving a promissory note to a member to pay a benefit;
• a person giving a promissory note to a SMSF as a contribution; or
• a combination of the above two transactions, often within a very short period of time.

At the time of issue (soon after the 2009 Federal Budget announcements regarding the reduction in concessional contribution caps), the ATO was concerned that some SMSF members might try to artificially utilise the current concessional caps before they were halved from July 1, 2009.

Example

John (60) is a member of a SMSF. Following the 2009 Federal Budget announcements, John realised that the level of concessional contributions he could make to super would halve from $100,000 to $50,000 from July 1, 2009. John was eligible to make personal deducted contributions to super and decided he wanted to maximise the level of personal deducted contributions for the year ended June 30, 2009.

However, as he didn’t have sufficient cash available to make the contribution, he drew a promissory note in favour of the SMSF for $100,000.

On its own, this type of transaction may not be in breach of the rules. The ATO’s concern is when the use of a promissory note in these circumstances is actually non-commercial. Such non-commercial use could arise if the note is:

• intended to be honoured only after a significant time has passed;
• never intended to be honoured at all; or
• immediately re-endorsed back to the SMSF.

As John is retired and over 60, he commences a pension after July 1, 2009. He decides to make a $100,000 withdrawal from his fund, which is 100 per cent tax free because of his age. The current assets in his fund are largely comprised of illiquid assets, being direct property investments. In order to fund the withdrawal, the SMSF endorses the promissory note back to John.

As the issuer and holder of the note, the promissory note is effectively cancelled.

Arrangements like the above are those that will come under scrutiny from the ATO. Similar scrutiny would apply where, for example, a SMSF makes a benefit payment to a member by way of promissory note, which the member then endorses back to the SMSF as a contribution (whether as a concessional or non-concessional contribution). These arrangements could arise as part of a recontribution strategy but remove the need to physically transfer cash or liquidate an asset.

Example

Jenny is a member of a SMSF with an account balance of $500,000. Of this, $400,000 is invested in a direct property asset, with the balance invested in cash and managed funds. Jenny is over 60 and retired and would like to transfer the property out of her SMSF so she can live in it during her retirement. The property currently has an unrealised capital gain of $150,000 and she would like to minimise the capital gains tax (CGT) consequences if possible.

Jenny is aware that she could commence a pension first, but that an in-specie transfer of the property to her as a member benefit cannot be done as a pension payment, and treating it as a lump sum withdrawal would give rise to CGT consequences.

As a result, Jenny starts a pension from her SMSF. She makes a pension payment of $400,000 to herself by way of the issuance of a promissory note. Soon after, Jenny decides to purchase the property from her SMSF (with a purchase inside pension phase being CGT free). She endorses the promissory note back to the SMSF in exchange for the transfer of title in the asset. Consequently, she now owns the property outside the fund, and there has been no physical payment of cash. The promissory note is cancelled.

Transactions such as this will be scrutinised by the ATO as there is no intention of the promissory note ever being honoured.

Whilst not stating that a breach of superannuation law arises from these arrangements, the ATO has flagged that the non-commercial use of negotiable instruments does give rise to a number of considerations, such as:

• benefit payment standards may not be met;
• contribution standards not being met; and
• restrictions on SMSFs acquiring assets from related parties or providing financial assistance to members or their relatives being breached.

Each case would be reviewed on its own particular facts, however, in order to ensure that clients do not come under unwarranted scrutiny from the ATO, the use of negotiable instruments (particularly promissory notes) should be avoided where possible. Where they cannot be avoided, advice should be sought to support a position that the issues discussed in this Taxpayer Alert do not arise for the client and their SMSF.

Bryan Ashenden is senior manager technical and advocacy at BT Financial Group.