Non-commercial terms of a limited recourse borrowing arrangement for some time now have been acknowledged by the Australian Taxation Office (ATO) as schemes that will be subject to the non-arm’s length income (NALI) provisions in section 295-550(1) of the ITAA 1997. This followed with practical compliance guidelines (PCG 2016/5) that set out ‘safe harbour’ terms for these non-commercial LRBAs to comply by 31 January 2017. However, further guidance was required from the Commissioner as to how he would look to apply NALI to both ordinary and statutory income derived by a SMSF under certain related party (or non-bank) borrowing arrangements.
We have now seen the release of tax determination, TD 2016/16 which considers whether
ordinary or statutory income of a self-managed superannuation fund will be non-arm’s length income under subsection 295-550(1) of the Income Tax Assessment Act 1997 (ITAA 1997) when the parties to a scheme have entered into a limited recourse borrowing arrangement on terms which are not at arm’s length?
In doing so, TD 2016/16 considers it necessary to identify both the:
- steps of the relevant scheme; and
- parties that deal with each other under the scheme.
Having identified both of these, paragraph 295-550(1)(b) of the ITAA 1997 requires a determination of the amount of ordinary or statutory income that the fund might have been expected to derive if the same parties to the scheme had been dealing with each other on an arm’s length basis under each identified step of the scheme.
Therefore, it is necessary to identify what the terms of the borrowing arrangement may have been if the parties were dealing with each other at arm’s length (what the ATO calls in TD 2016/16, ‘the hypothetical borrowing arrangement’).
Having identified such an arrangement between the SMSF and the lender on terms which are on an arm’s length basis, it is then necessary to establish whether it is reasonable to conclude that:
- the trustee ‘could have’ acquired the asset under the hypothetical borrowing arrangement; and
- the trustee ‘would have’ entered into the hypothetical borrowing arrangement.
Trustees can use the Commissioner’s safe harbour guidance in PCG 2016/5 to help determine what is arm’s length terms for a LRBA.
Understanding ‘could have’
The ATO in TD 2016/16 considers the following factors as being relevant in considering whether an SMSF trustee could have acquired the asset under the hypothetical borrowing arrangement:
- the terms of the trust deed and governing rules of the SMSF that is a party to the arrangement, and whether these rules pose any impediment to the fund acquiring the asset under the hypothetical borrowing arrangement;
- whether or not the fund has sufficient capital available, having regard to liquidity and cash flow requirements, to complete the purchase depending on the extent that an arm’s length borrowing limits the amount that can be borrowed to acquire the asset;
- the ability of the fund to service the arm’s length terms of the hypothetical borrowing arrangement; and
- any legislative or regulatory impediment that might prevent the fund from acquiring the asset under the hypothetical borrowing arrangement, including any covenants under section 52B of the SISA that are required to be included in the fund’s governing rules.
‘Would have’ entered into?
The Commissioner has indicated that the following factors are relevant in considering whether the fund trustee would have entered into the hypothetical borrowing arrangement:
- whether the hypothetical borrowing arrangement would be consistent with the fund’s investment strategy at or immediately prior to the purchase and/or obtaining finance under the LRBA;
- whether the hypothetical borrowing arrangement would be an optimal use of their funds; and
- whether the hypothetical borrowing arrangement, taking into account the income including any future capital gains that the asset acquired is expected to generate, would be earnings accretive. For example, when the scheme is implemented on arm’s length terms, the rate of interest may be so high that it results in the scheme making no real return or in fact a loss. This suggest that the fund would reasonably be expected to have not entered into the scheme on arm’s length terms.
Is the arrangement reasonable?
Where it is reasonable to conclude that the fund could not have, or would not have entered into the hypothetical borrowing arrangement, the fund will have likely derived more ordinary or statutory income from the non-arm’s length scheme that would have been expected from the hypothetical borrowing arrangement – as result, the Commissioner will determine that the NALI provisions apply.
Where the SMSF can objectively establish with evidence that it could have and would have entered into the hypothetical borrowing arrangement, a comparison can then be made of the:
- fund’s ordinary and statutory income derived by the scheme (where the parties have not been dealing with each other at arm’s length and have entered into a LRBA on terms which are not at arm’s length); and
- income under the hypothetical borrowing arrangement
Within TD 2016/16, the following example has been provided to help explain how the NALI provisions can apply to ordinary or statutory income derived by a SMSF:
Example: SMSF acquired a commercial real property financed by a LRBA for rental income
An SMSF acquired a commercial real property from a third-party at market value of $1,000,000 on 1 July 2015, which the fund derives rental income of $1,000 per week. The fund initially financed the purchase under a LRBA on terms consistent with section 67A of the SISA, with the lender being a related entity to the fund. At the time of the acquisition the fund SMSF had an amount of $25,000 cash at bank, with no other property at the time of purchase, and the fund’s investment strategy specifying a diversified asset portfolio between cash, listed shares and property.
The following table outlines the terms of the LRBA under the scheme where the parties were not acting at arm’s length (the ‘Current LRBA’) compared with the terms under the hypothetical borrowing arrangement (for the purposes of this example, the terms adopted are consistent with PCG 2016/5) to acquire the commercial real property:
|Current LRBA||Hypothetical borrowing arrangement|
|Amount sourced from fund capital||0||$300,000|
|Interest rate||0%||Variable, 5.75% p.a. for the 2015-2016 year*|
|Term of the loan||25 years||15 years|
|Loan to Market Value ratio (LVR)||100%||70%|
|Security||Mortgage in favour of the Lenders is registered in respect of the asset||Mortgage in favour of the Lenders is registered in respect of the asset|
|Personal guarantee||No personal guarantees or other security are given to the lenders in relation to repayment of the loan||Not required|
|Nature and frequency of repayments||No repayment is required until the end of the term of the loan – $0 monthly repayments||Monthly repayments of both principal and interest – approximately $5,800 per month at 5.75% p.a. for the 2015-16 year|
* ATO safe harbour rate outlined in PCG 2016/5, which is a variable rate that is subject to change for the 2016-17 and future income years.
For the hypothetical borrowing arrangement:
- a loan to value ratio (LVR) of 70% under the hypothetical borrowing arrangement required the SMSF to source $300,000 of its own funding to make the purchase;
- the weekly rental of $1,000 per week is not sufficient to meet the monthly repayments of both principal and interest calculated to be approximately $5,800 per month at 5.75% p.a. for the 2015-16 year (repayments will change depending on the rate in later income years); and
- under the hypothetical borrowing arrangement, it is assumed that the SMSF would not be in breach of any of its legislative and regulatory requirements.
As a result, based upon the above facts, it is clear that the SMSF could not and would not have entered into the arm’s length hypothetical borrowing arrangement. This conclusion is based upon the fact that:
- the SMSF did not have sufficient funds available to reduce the level of borrowings to finance the purchase to a level that satisfies the 70% LVR requirement; and
- the hypothetical borrowing arrangement, taking into account the weekly rental and any future capital gains, would not be earnings accretive.
Therefore, because the fund could not have and would not have acquired the commercial real property under the hypothetical borrowing arrangement, the income that the fund would be expected to derive from the scheme if the parties were dealing with each other at arm’s length is nil. If the parties were dealing with each other at arm’s length in relation to the scheme the investment in the commercial real property would not occur, as no arm’s length LRBA could have been entered into.
As a result, the Commissioner determines that the $1,000 per week rental income the SMSF receives is NALI.
Deadline to comply
It is important to remember that the Commissioner has imposed a deadline of 31 January 2017 for trustees to comply with PCG 2016/5 or terms that demonstrate arm’s length terms. This includes payment of principal and interest amounts for the 2015-16 income year by this date.