Contributed by Bryce Figot, Director and Daniel Butler, Director, DBA Lawyers
The ATO has released Practical Compliance Guideline PCG 2016/5 containing important information detailing interest rates, loan-to-value ratios (LVRs) and other terms that constitute safe harbours for SMSF limited recourse borrowing arrangements (LRBAs) so that arrangements will be taken to be consistent with an arm’s length dealing.
Broadly, LRBAs consistent with arm’s length terms should not give rise to non-arm’s length income (NALI). On the other hand, LRBAs that are not consistent with arm’s length terms will attract the high rate of tax that applies to NALI (see below).
The ATO’s guideline is critical for:
- SMSF trustees that have already entered into LRBAs as action might be required, and
- SMSF trustees that are considering entering into LRBAs,that are not financed by a bank.
SMSF trustees that have already entered into non-bank LRBAs might need to revise the terms of the loan or take other corrective action by 30 June 2016. In view of the ATO safe harbours, it would be wise to review every LRBA that is not financed by a bank before 30 June 2016.
To the extent that an SMSF has NALI, that income is taxed at a very high rate (47% in the 2016 financial year) even if the fund is in pension mode.
When the predecessor of the current LRBA laws (ie the old instalment-warrant exception in the now repealed s 67(4A)) was first introduced in 2007, a question mark hung over non-bank loans that had terms favouring the SMSF. In this regard, see ATO Taxpayer Alert TA 2008/5.
In 2010, the ATO released ATO ID 2010/162, which considered whether an SMSF trustee contravened the arm’s length provisions of the Superannuation Industry (Supervision) Act 1993 (Cth) if it borrowed money from a related party of the SMSF under a limited recourse borrowing arrangement on terms favourable to the SMSF. The ATO said it did not contravene the arms’ length provisions.
In the December 2012 NTLG minutes, the issue of interest-free or low-interest loans to SMSF trustees was considered. These minutes record that “ATO ID 2010/162 failed to identify whether any other provisions of the superannuation or tax law would be contravened by the trustee entering into a no interest or low interest limited recourse loan arrangement”. The minutes went on to state:
“The ATO position on low rate loan arrangements and LRBA is that that they do not generally invoke a contravention of the SISA, do not give rise to non-arm’s length income under s 295-550 of ITAA 1997, do not invoke Pt IVA of ITAA 1936 and are not considered to give rise to contributions to the SMSF just from that one fact alone [Emphasis added].”
In December 2014, the ATO released ATO ID 2014/39 and ATO ID 2014/40 (since replaced — but not practically altered — by ATO ID 2015/27 and ATO ID 2015/28 respectively). These both considered non-bank LRBAs with nil interest being charged and both stated that the ATO’s view is that the arrangements did give rise to NALI. Accordingly, the position became that non-bank LRBAs should be on the same terms that would be agreed with an arm’s length lender.
In December 2014, the ATO released a page on their website (since removed) stating:
“To be able to demonstrate that NALI does not arise, a fund trustee entering into an LRBA with a related-party borrower should obtain and keep documentation that enables them to establish that the terms of the loan, taken together, and the ongoing operation of the loan are consistent with what an arm’s length lender dealing at arm’s length would accept in relation to the particular borrowing by the fund trustee.”
Accordingly, the importance of benchmarking terms of non-bank LRBAs to what, for example, a bank might offer was reinforced to the entire industry.
However, in a practical sense, benchmarking can be difficult. Accordingly, the ATO safe harbours are a very positive step and the ATO should be commended for developing and releasing them.
The safe harbours
The Guideline states that the ATO:
“will accept that an LRBA structured in accordance with this Guideline 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”.
There are two safe harbours for LRBAs, one for loans to acquire real property and one for loans to acquire listed shares or units in a listed trust. Essentially, the required terms for LRBAs are as follows:
Type of asset being acquired
Real property (any kind)
RBA Indicator Rates for banks providing standard variable housing loans for investors (5.75% for the 2015/16 year)
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))
Seven years for original loan (any refinancing will be reduced by duration of the previous loan(s))
Maximum Loan-to-value ratio
A registered mortgage
A registered charge/mortgage or similar security (that provides security for loans for such assets)
Nature and frequency of repayments
Monthly repayments on a “principal and interest” basis
Same as real property
Written and executed
Written and executed
The guideline also provides further detailed guidance regarding the specifics of setting interest rates, particularly for fixed versus variable loans.
Rectifying non-compliant LRBAs
If the existing LRBA does not meet the safe harbours set out above, the guideline provides the following options:
- Option 1 — Change the terms so that they are consistent with an arm’s length dealing by 30 June 2016.
- Option 2 — Bring the LRBA to an end by 30 June 2016.
- Option 3 — Refinance to a commercial lender by 30 June 2016.
The ATO also requires all non-bank LRBAs to be put on arm’s length terms on or before 30 June 2016. This includes, for example, SMSFs being required to pay a full year’s repayments under loans prior to 30 June 2016. This may place many SMSFs under financial stress given that they only have limited time available to come up with substantial cash funding.
Moreover, from 1 July 2016, LRBAs covered by the ATO’s safe harbour will need to make regular monthly repayments of principal and interest. Some non-bank LRBAs may have allowed more flexible repayments such as only requiring annual payments and some only required full repayment on finalisation of the loan term.
Because the 30 June 2016 deadline is near, advisers (and SMSF trustees) should act immediately as time is needed to obtain advice, prepare documents and arrange the cash flow before the deadline. If the 30 June deadline is not practical and is likely to be overshot, then expert advice should be obtained as a special approach to the ATO may be required.
Assets not covered by the safe harbours
First, the safe harbours only expressly apply to:
- • real property
- • shares in a stock exchange listed company, and
- • units in a stock exchange listed unit trust.
For example, if an SMSF trustee has borrowed from a non-bank to acquire units in a specific class of units in certain managed funds, what action should the SMSF trustee take? Many think of such an investment as being tantamount to a listed security, but technically it’s not.
Perhaps somewhat more controversially, what if an SMSF trustee has borrowed to acquire units in a related trust such as a reg 13.22C/Div 13.3A unit trust?
The onus is on the SMSF trustee to obtain sufficient and appropriate evidence to support the arm’s length nature of the terms of their LRBA. This may be difficult where there is no readily available market information and quotes, and proposals from third parties and other sources may need to be researched and documented.
Indeed, some may not wish to continue with a non-bank lender and may prefer to refinance with a bank.
Calculating the loan-to-value ratio
How is the LVR calculated? More specifically, is the “value” of the real property its value excluding GST, stamp duty and other similar costs? In the absence of ATO clarification, the conservative approach is to assume that the answer is yes.
The ATO require the market value to be established at the time of the relevant loan. Thus, the market value of the asset will generally be at the time of refinancing or if there is no refinancing at the date of the original loan.
Multiple assets for one loan
The Guideline reinforces that it is possible to have multiple loans to acquire one asset. More specifically, if more than one loan is taken out in respect of the acquisition of the asset, the total amount of all those loans must not exceed 70% for real property or 50% for listed units or shares.
What does real property mean?
The Guideline refers to real property. On first blush, it seems to cover all real property, referring to “real property, whether that property is residential or commercial premises (including property used for primary production activities)”.
However, some assets may or may not be seen as real property, such as:
- An interest in real estate as tenants in common — technically, this is real property but the ATO does not expressly mention a non-bank lending to an SMSF to acquire a, for example, 50% tenants in common interest in a house using a 70% LVR and a 5.75% interest rate.
- Life interests in real estate or listed shares/units — technically, this is real property, but similar to tenants in common we doubt whether the ATO would be comfortable with an SMSF using these safe harbours to acquire such an asset.
- Shares in a real estate company — there exists “company title” whereby a property does not have a plan of subdivision per se but rather comprises a number of apartments and a company owns all the property and by buying, for example, all of the C class shares the owner of the shares has exclusive possession to apartment number 3. Technically, such shares are not real property. However, there are certain areas of the laws that essentially allows them to be treated as real property (such as the CGT main residence exemption). The conservative position would be to treat such shares in a real estate company as not constituting real estate for the safe harbour relief and apply to the ATO for SMSF specific advice.
Limits of safe harbours
The safe harbours do not state that just because the terms in the guideline are satisfied NALI can never occur. Rather, they have the following more restrained comment “an LRBA structured in accordance with this Guideline 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” (emphasis added). For example, if an SMSF acquires an asset for a non-market value from a related party, NALI could apply (refer Darrelen Pty Ltd as Trustee of the Henfam Superannuation Fund v FC of T2010 ATC ¶20-180).
The safe harbours are critically important. They are a very practical solution and the ATO should be commended for its positive manner in managing these non-bank LRBAs.
All non-bank LRBAs should be reviewed and appropriate taken by 30 June 2016.