Non-arm’s length income and related party SMSF limited recourse borrowing arrangements
If an SMSF has entered into a limited recourse borrowing arrangement (‘LRBA’) where the lender may be a related party or someone other than a main-stream bank, the arrangement may attract non-arm’s length income and fall outside the concessional tax regime applicable to SMSFs.
Executive summary
You may need to take action before 1 July 2016. Failure to do so might cause a significant tax bill. As soon as possible you should:
- contact our office to discuss this article;
- review the existing terms of your SMSF’s LRBA;
- determine if the existing terms are within the new ATO safe harbours discussed below; and
- if the existing terms are not in the safe harbours, select one of the following options:
OPTION 1: alter the existing terms before 1 July 2016 so that they are in the safe harbours;
OPTION 2: terminate the LRBA before 1 July 2016;
OPTION 3: document and retain evidence so that you can demonstrate that the LRBA was entered into and maintained on terms consistent with an arm’s length dealing;
OPTION 4: re-finance with a bank or other lender on arms-length, commercial terms before 1 July 2016; or
OPTION 5: instruct us to approach the ATO on your behalf as soon as possible.
1 Background information
In December 2015, the ATO released commentary on their website, as follows:
NON-ARM'S LENGTH LIMITED RECOURSE BORROWING ARRANGEMENTS
… the non-arm’s length income (NALI) provisions can apply when an SMSF trustee undertakes .. LRBAs … established or maintained on terms that are not consistent with an arm’s length dealing … NALI is currently taxed at 47%.
Full commentary available here.
What you should do by 30 June 2016
SMSF trustees should review any LRBA you have to determine whether it was established and maintained on terms that are consistent with an arm’s length dealing. If this is not the case, we strongly encourage you to take steps to ensure that it is on terms consistent with an arm’s length dealing by 30 June 2016 or to bring the LRBA to an end by that date. You may wish to seek professional advice if you are unsure.
2 Safe Harbours
In April 2016, the ATO released a guideline that sets out the 'safe harbour' terms. If those terms are used, the ATO says it will accept that the LRBA is consistent with an arm's length dealing and that the NALI provisions do not apply purely because of the terms of the borrowing arrangement.
You should read the ATO’s Practical Compliance Guideline (PCG) 2016/5 explaining the safe harbours provisions in its entirety here . However, as an introduction, we provide the following summary table:
| TYPE OF ASSET BEING ACQUIRED | REAL PROPERTY (ANY KIND) | STOCK EXCHANGE LISTED SHARES OR UNITS |
| INTEREST RATE | Reserve Bank of Australia Indicator Lending Rates for banks providing standard variable housing loans for investors. Applicable rates:
| Same as real property + 2% |
| TERM OF LOAN | 15 years for original loan (any refinancing will be reduced by duration of the previous loan(s)) | 7 years for original loan (any refinancing will be reduced by duration of the previous loan(s)) |
| MAXIMUM LOAN-TO-VALUE RATIO | 70% (an LRBA in existence on publication of these guidelines, the trustees may use the market value of the asset at 1 July 2015) | 50% (an LRBA in existence on publication of these guidelines, the trustees may use the market value of the asset at 1 July 2015) |
| SECURITY | A registered mortgage | A registered charge/mortgage or similar security (that provides security for loans for such assets) |
| PERSONAL GUARANTEE | Not required | Not required |
| NATURE & FREQUENCY OF REPAYMENTS | Monthly repayments on a 'principal and interest' basis | Same as real property |
LOAN AGREEMENTS | Written and executed | Written and executed |
3 Your options
As set out at the start of this article, if the existing terms of the LRBAs are not in the safe harbours, you have the following options:
OPTION 1: alter the existing terms before 1 July 2016 so that they are in the safe harbours. If pursuing this option we note that the ATO states in the guideline:
Given this, we 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 an 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.
In addition, 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.
OPTION 2: terminate the LRBA before 1 July 2016;
OPTION 3: document and retain evidence so that you can demonstrate that the LRBA was entered into and maintained on terms consistent with an arms' length dealing. If pursuing this option we note that the ATO states in the guideline:
If SMSF trustees have entered into an arrangement which does not meet all of the 'Safe Harbour' terms set out in this Guideline, whilst the trustees are unable to be assured that the Commissioner will accept the arrangement to be consistent with an arms' length dealing, it does not mean that the arrangement is deemed not to be on arms' length terms. It merely means that there is no certainty provided under this Guideline. The trustees will need to be able to otherwise demonstrate that the arrangement was entered into and maintained on terms consistent with an arms' length dealing. One example of how a trustee may demonstrate this is by maintaining evidence that shows their particular arrangement is established and maintained on terms that replicate the terms of a commercial loan that is available in the same circumstances
OPTION 4: re-finance with a bank or other arm’s length lender before 1 July 2016; or
OPTION 5: contact the ATO as soon as possible as a tailored submission needs to be made if the 30 June deadline can’t be satisfied.
Please contact Baumgartner Super on 1300 04 7673 or info@baumgartnersuper.com.au if you would like our assistance.
IMPORTANT COMMENT
This article has been issued to assist you in structuring your Fund’s LRBA to take advantage of the ATO’s “safe harbours” which will ensure that it will not be taxed as if the arrangement involved the receipt of non-arm’s length income (NALI).
NALI can still be avoided if the arrangements you have entered into, whether involving a related lender or not, are structured on strictly commercial, market-place terms that do not provide any party with a concession simply because that party is related or otherwise favoured. That is, no “mates rates”.
If your LRBA structures are on these terms, there may be no need to change them. If you have any doubt, please seek appropriate advice from Baumgartner Super.