A promissory note (P-note) is a financial instrument, where the issuer of the P-note has agreed and is obliged to make a repayment of a sum of money. A P-note would usually contain all the relevant terms such as interest, the time of maturity, etc.

So being a financial instrument, a P-note should be looked upon as a loan.

How did the fund come to acquire the P-note?

Where a P-note is held by an SMSF, it is important that it was not issued by members of the fund or their relatives, so as to ensure that there are no breaches of section 65 of the Superannuation Industry (Supervision) Act 1993 (SIS Act).  Section 65 prohibits an SMSF from lending to a member of the fund or to a relative of a member of the fund.

A loan to a related party of the members of the fund, such as companies or trusts, would constitute an in-house asset under section 71 of the SIS Act.   Accordingly, if the loan is to a Part 8 associate such as a company or trust, it would have to comply with sections 82 and 84 of the SIS Act.  That is, the P-note (along with any other in-house assets) could not represent more than 5% of the fund’s total assets.

The terms of P-note – are they market value/arm’s length?

No matter what the identity of the borrower, the terms of the P-note should be arm’s length to reflect the risk of the borrowing.  A failure to ensure that terms are not arm’s length could give rise to a breach of section 109 of the SIS Act.  If the borrower is a related party and the terms are more favourable to the borrower than arm’s length terms, this would give rise to a breach of section 109 and possibly a breach of section 62 of the SIS Act (the sole purpose test).

If the terms of the P-note are more favourable to the fund than what they would be under an arm’s length arrangement, the income from the P-note could be assessed as non-arm’s length income (also referred to as NALI) under section 295-550 of the Income Tax Assessment Act 1997.

Valuation of the P-note

As per Regulation 8.02B of the regulations to the SIS Act, the trustee of the SMSF is required to value its assets at their market value as at the end of the income year.  Accordingly, it is important that the trustee of the SMSF (in practice, as provided by the accountant of the SMSF) explains the basis on which the P-Note was valued.


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