Getting your related party LRBAs in order
While new and existing related party limited recourse borrowing arrangements need to comply with safe harbour provisions, it is not the only option, David O'Connell writes.
While borrowings from related parties has been part of the self-managed superannuation fund (SMSF) gearing landscape for some time, there has been a lot of discussion about what terms are appropriate for such loans, particularly around the interest rate.
From the outset, trustees have realised that there can be a financial benefit in a reduced interest rate as it results in a reduction in assessable income for the lender and an increase in assessable income for the SMSF. As the SMSF usually has the lower marginal tax rate, the reduced interest rate results in a lower overall tax liability.
The Australian Taxation Office (ATO) has had concerns about related party limited recourse borrowing arrangements (LRBAs) with interest rates less than commercial rates for some time and in 2008 it issued a taxpayer alert (TA 2008/5) in relation to them.
Its concern was that a low interest rate could be characterised as a contribution, a position it had revised by 2012 when in a meeting of the superannuation technical sub-committee of the National Tax Liaison Group (NTLG).
It stated that as a discounted interest rate did not result in an increase in the capital of the fund, it would not be recognised as a contribution received by the SMSF.
While there wouldn't be any deemed contribution, there were a number of other concerns related to related party LRBAs with discounted interest rates, not least of which was the possible application of non-arm's length income (NALI) provisions.
In short, NALI for an SMSF is income derived from a scheme where the parties are not dealing with each other at arm's length and the income is greater than would be expected had the parties been dealing with each other at arm's length.
NALI is taxed at the highest marginal rate and that rate does not just apply to the excess but to all the income from the scheme. In addition, the rate is unaffected by whether the fund is in accumulation or pension phase.
The classic example given is where a related party is leasing a property from an SMSF and paying rent in excess of market rates. In this case, all the rental income will be taxed at 47 per cent, not just the difference between what was paid and the market rates.
While the ATO has in the past published private binding rulings stating it would not apply NALI provisions to a related party LRBA which had a nil interest rate, it is clear that those rulings were made before the formation of their current opinion outlined in ATO ID 2014/39 and ATO ID 2014/40 published in December 2014.
In each case, one of the characteristics of the loan was that the lender was not charging an interest rate and was not otherwise being compensated by the SMSF for lending the funds, leading the ATO to determine that the NALI provisions would be applied in both cases.
Safe harbour provisions
These determinations caused significant concern among SMSF trustees with related party borrowings, the vast majority of whom were trying to do the right thing. How could they be sure that their arrangement wouldn't fall foul of the NALI provisions?
In recognition of this, the ATO published guidance on this issue in April 2016 in the form of a Practical Compliance Guideline (PCG 2016/5).
These PCGs are a recent development from the ATO and seek to provide taxpayers and professionals with insights into how the ATO will assess arrangements for compliance with the relevant legislation.
While these PCGs are not public rulings which bind the ATO to its expressed view, it should nonetheless be seen as the ATO's published guidance and it is unlikely it would take a position that contradicts it.
The PCG contains safe harbour provisions for setting the terms for a related party loan with different provisions applying whether the loan was used to acquire real property or listed shares or units.
Importantly, while a loan that complies with the safe harbour provisions will be deemed to comply with the legislation, it does not mean that loans that do not comply with the provisions will be deemed to be in breach of the legislation.
The ATO will continue to assess each of those loans on their own merit. In addition, these provisions are only applied where there is a question regarding the commerciality of a loan.
As such, the NALI provisions will not be applied where the loan is sourced from a commercial lender even if the terms do not align with the requirements outlined in Table 1.
Similar safe harbour provisions apply to arrangements where the asset acquired is a listed share or unit, though the provisions are more restrictive. Further details can be found in PCG 2016/5.
ATO's approach for LRBAs already established
The PCG also contained relief for LRBAs already in existence and the ATO stated that it will not take compliance action against trustees for LRBAs for the 2014/2015 and earlier financial years provided that the principal and interest payments are on an arm's length basis for the 2015/2016 financial year, and by 30 June 2016 either:
- The LRBA is on terms that are consistent with an arm's length dealing; or
- The LRBA is brought to an end.
After publication of the guidelines, the ATO received a significant number of individual requests for an extension of time and in reviewing these requests, it has recognised that there are a number of legitimate reasons why a trustee would not have been able to seek advice and implement a strategy to bring their loan in line with the safe harbour provisions by 30 June 2016.
As such, the ATO has extended the deadline to 31 January 2017. Trustees wishing to access the relief will still need to make principal and interest payments on an arm's length basis for the 2015/2016 financial year but will have until 31 January 2017 to do so.
$500,000 lifetime non-concessional cap
The PCG provides examples of loans that do not satisfy the arm's length provisions and illustrates the options which are available to the SMSF trustees.
In instances where a loan had a loan-to-value ratio (LVR) greater than the maximum allowed, one of the options was to make repayments sufficient to bring it in line with the maximum LVR.
An obvious way to fund this repayment where the fund does not have other sufficient assets to do so would be by making a non-concessional contribution.
This option was complicated by the budget announcement that the Government, if returned, would introduce a new lifetime non-concessional contribution cap of $500,000.
However the Treasurer, Scott Morrison, has stated that the Government will offer relief from this cap where the non-concessional contributions are required by the SMSF trustee to bring an LRBA, which was in place before the budget, in line with the safe harbour provisions as outlined in the PCG 2016/5.
Conclusion
Due to the comfort and certainty provided by the safe harbour provisions, the default position should be to ensure that new and existing related party LRBAs comply with these provisions, however, that is not the only option.
In some cases, it may be appropriate to use the benchmarking method whereby the trustee determines what they would be able to get from a commercial lender and then set the terms of the related party loan against that. Where they decide to take that option they need to ensure that the benchmarking process is sufficiently robust and well documented to satisfy their auditor and the ATO.
David O'Connell is a senior technical consultant at BT Financial Group.
Recommended for you
When entering paid employment, it’s not long before we are told that we’ll need to lodge a tax return but there are times when a person will be excepted.
Anna Mirzoyan examines how grandfathering affects income support payments and how factors such as paying for aged care can impact them.
There are specific requirements that only apply to trustees of self-managed superannuation funds, writes Tim Howard, including the allocation in their investment strategy.
Investments bonds offer a number of flexible, tax-advantaged benefits, writes Emma Sakellaris, but these are often overlooked as old fashioned when it comes to portfolio allocations.
