With the ATO having previously issued guidance on the application of section 295-550 of the ITAA 1997 – the non-arm’s length income (NALI) provisions applying to non-commercial limited recourse loan arrangements, we have now seen long-awaited guidance through Practical Compliance Guidance, PCG 2016/5 – Income tax – arm’s length terms for Limited Recourse Borrowing Arrangements established by self managed superannuation funds.
The following table outlines terms on which SMSF trustees may structure their LRBAs consistent with an arm’s length dealing – that is, for income tax compliance purposes, the Commissioner will accept that the LRBA is structured in way that is consistent with being commercial and that the NALI provisions do not apply (purely because of the terms of the SMSF borrowing).
Where a trustee has entered into an arrangement that does not meet all of the ‘Safe Harbour’ terms set out within PCG 2016/5, it does not mean that the arrangement will be deemed to be non-arm’s length and a 47% tax rate apply. It merely means that the no certainty is provided under the PCG 2016/5 guidance and it will require trustees to be able to otherwise demonstrate that the arrangement was entered into and maintained on terms consistent with an arm’s length dealing. This could for example be undertaken by the trustee through evidence that shows their arrangement has been established and maintained on terms that replicate that of an independent third-party lender (e.g. bank) that is available in the same circumstances.
Let’s take a look at the two examples provided by the ATO:
Example 1 – Real property
A complying SMSF borrowed money under a LRBA on terms consistent with section 67A of the SISA. It used the funds to acquire commercial property valued at $500,000 on 1 July 2011.
- The borrower is the SMSF trustee.
- The lender is an SMSF member’s father (a related party).
- A holding trust has been established, and the holding trust trustee is the legal owner of the property until the borrowing is repaid.
The loan has the following features:
- the total amount borrowed is $500,000
- the SMSF met all the costs associated with purchasing the property from existing fund assets
- the loan is interest free
- the principal is repayable at the end of the term of the loan, but may be repaid earlier if the SMSF chooses to do so
- the term of the loan is 25 years
- the lender’s recourse against the SMSF is limited to the rights relating to the property held in the holding trust, and
- the loan agreement is in writing.
The ATO does not consider that this LRBA has been established or maintained on arm’s length terms. This is consistent with their view in ATO interpretative decisions, ATO ID 2015/27 and ATO ID 2015/28. The income earned from the property, which is rented to an unrelated party, gives rise to NALI.
At 1 July 2015, the property was valued at $643,000.
The SMSF has not repaid any of the principal since the loan commenced.
To avoid having to report NALI for the 2015-16 year (and prior years) the Fund has a number of options, including:
- Alter the terms of the loan to meet guidelines – this includes the following:
- Ability to utilise the 1 July 2015 market value of the property to determine the 70% LVR ($643,000 x 70% = $450,100). This requires the trustees to reduce the loan principal by $49,900 before 30 June 2016.
- Ensuring loan term does not exceed 11 years from 1 July 2015, being the remaining term of a 15 year loan.
- The SMSF can use a variable interest rate, or alternatively lock-in a fixed rate for up to 5 years.
- The interest rate to apply for the current income year is 5.75% (FY2016). The trustee must determine and pay the appropriate amount of principal and interest payable for the year – the calculation must factor in the opening balance ($500k), remaining terms and timing of repayments (including $49,900).
- Post 1 July 2016, the new LRBA must continue under terms that comply with the ATO’s guidelines relating to real property at all time – e.g. make monthly P&I repayments using the RBA housing indicator rate (relevant interest rate)
- Refinance through a commercial lender
- Pay out the LRBA and bring it to an end before 30 June
For further details regarding the example of the collection of listed shares, refer to PCG 2016/5.
ATO’s compliance approach for LRBAs established before 30 June 2016
The ATO has indicated that it will not select an SMSF for an income tax review for the 2014-15 year or earlier years purely because the SMSF has entered into a LRBA. However, this is conditional on the SMSF trustee ensuring that any LRBAs that their fund has is on terms consistent with an arm’s length dealing by 30 June 2016 or, alternatively, is brought to an end by 30 June 2016.
Furthermore, the ATO has indicated that payments of principal and interest for the year ended 30 June 2016 must be made under LRBA terms consistent with an arm’s length dealing. In other words, SMSF trustees have an opportunity to review the terms of their funds’ LRBAs before 30 June 2016. The terms of their LRBAs will not be subject to any further compliance action for the 2014-15 income years (or before) if, by the 30 June 2016:
- the LRBA is on terms that are consistent with an arm’s length dealing, or
- the LRBA is brought to an end, and the payments of principal and interest made are made under LRBA terms consistent with an arm’s length dealing.
This guidance provides by the ATO provides much-needed safety from the NALI provisions being applied to certain limited recourse borrowing arrangements. Whilst a trustee has an ability to swim outside the flags, it does so at risk and will require them to be able to demonstrate that the borrowing is undertaken on commercial terms.
What do you think of the guidelines provided by the ATO?