SMSF guidelines on related party borrowings
Catherine Chivers runs through the ATO's new guidelines which seek to clarify safe harbour terms for an SMSF when they structure their LRBAs to comply with arm's length dealings.
On 6 April 2016, the Australian Taxation Office (ATO) released Practical Compliance Guideline PCG 2016/5, which seeks to provide increased clarity surrounding the ‘safe harbour' terms that a self-managed superannuation fund (SMSF) can structure limited recourse borrowing arrangements (LRBAs), such that they are consistent with the principle of ‘arm's length dealings'.
The importance of an SMSF structuring LRBAs on arm's length terms
When an SMSF acquires an asset using LRBAs, where the terms of the arrangement are not conducted on an arm's length (or commercial) basis, the non-arm's length income (NALI) provisions contained within s.295-550 of the Income Tax Assessment Act 1997 could apply.
Where the NALI provisions apply, any ordinary or statutory income generated by the asset that is the subject of the borrowing will be taxed at 47 per cent, rather than the concessional maximum rate of 15 per cent, which applies to complying funds.
Policy intention of the NALI provisions
The intention of the NALI provisions is to prevent income being diverted into superannuation entities that receive concessional taxation, as a shelter against the normal tax rates applicable to other entities, and especially the comparatively punitive marginal tax rates that apply to individual taxpayers1.
NALI and how can it arise in the context of an LRBA
Income derived by an SMSF as beneficiary of a trust (other than because of the holding of a fixed entitlement) is considered to be NALI.
Additionally, even where the SMSF has a fixed entitlement to income of a trust, that income may still be assessed as NALI if it is:
- Derived from a scheme in which the parties were not dealing with each other at arm's length; and
- More than the SMSF might have been expected to derive if the parties had been dealing with each other at arm's length.
Other circumstances where NALI can arise include:
- Dividends which are paid to an SMSF by a private company (unless the dividend is consistent with arm's length dealings); and
- Income that is derived from investments that have non-commercial terms - for example, LRBAs with zero per cent interest loans.
Why are the ‘safe harbour' guidelines issued in PCG 2016/5 relevant to SMSFs now?
PCG 2016/5 follows on from ATOIDs 2015/27 and 2015/282, which provided clear confirmation of the Commissioner's view that borrowings on non-commercial terms (such as zero per cent interest rates) may result in NALI to the SMSF. Additional clarity was provided on this topic by an ATO announcement in October 2015 that they expected SMSF trustees with LRBAs to be on ‘commercial terms' by 30 June 2016.
Unfortunately at that time, there was no clear guidance provided by the Commissioner on what he would consider to be ‘commercial terms'. This necessitated the issuing of PCG 2016/5 to provide the required ‘safe harbour' conceptual definition of such a term.
A summary of the ‘safe harbour' guidelines
PCG 2016/5 applies to all LRBAs established under the provisions of s.67A of the Superannuation Industry (Supervision) Act 1993 (SISA) - and former provisions within superannuation law - irrespective of the actual commencement date of the LRBA.
The ‘safe harbour' terms applying to the acquisition of real property via an LRBA are:
1) Interest rates that are aligned with the Reserve Bank of Australia's Indicator Lending Rates for banks providing standard variable housing loans for investors;
2) Loan terms not exceeding a maximum period of 15 years (with a maximum period of five years available for fixed rate terms within that maximum 15 year period);
3) A Loan to Market Value Ratio not exceeding 70 per cent irrespective of whether the asset is commercial or residential property;
4) Repayments of both principal and interest occur on at least a monthly basis; and
5) A written and executed loan agreement supports each relevant LRBA.
Note: There are also separate ‘safe harbour' terms applicable for share acquisitions. These elements have not been addressed here.
Immediate action points for all advisers of SMSF clients with existing LRBAs
It is important that all SMSF trustees with existing LRBAs are satisfied by 30 June 2016 that theirs is consistent with dealing on an arm's length basis.
In meeting these requirements advisers may need to assist their various SMSF trustee clients in a number of ways. Such advice may ultimately involve any one of the following outcomes:
1) Altering any terms of the loan to meet the PCG 2016/5 requirements listed above;
2) Refinancing through a commercial lender;
3) Repaying the LRBA and bringing it to an end by 30 June 2016, and also ensuring that any required payments of principal and interest for the relevant part of the 2015-16 year are made. Such required payments may cause an SMSF to have cashflow constraints given the very limited time available between now and 30 June to access such funds.
All SMSF trustees will need to act swiftly to enable sufficient time to access relevant advice/documentation and facilitate any necessary cashflow transfers prior to 30 June.
If this timeframe is unlikely to be met, specific advice may be required to be developed now, which may well involve some form of negotiated outcome with the ATO.
Failure of the SMSF trustee to ensure their LRBAs are structured on an arm's length basis by 30 June 2016 will expose the fund to further compliance action for the 2014-15 and prior income years.
Action required from 1 July 2016 for all advisers of SMSF clients with existing LRBAs
To ensure that the LRBA remains covered by the ‘safe harbour' guidelines, regular monthly repayments of principal and interest will be required.
Prior to 1 July 2016, some LRBAs may well have had significantly more flexible arrangements.
This may mean that changes to the fund's investment mix are required in FY17 (and in later years), which also may necessitate change to its investment strategy. Such investment re-balancing may be particularly important in the case where a fund is either already paying a pension, or is looking to do so in the near-term.
Additional financial modelling may be required to determine if the fund can still meet its liabilities under the current investment mix, while also adhering to the ‘safe harbour' guidelines.
Frequently asked questions
What if my SMSF client's LRBA does not strictly meet the ‘safe harbour' terms - can the trustees still establish it is being maintained on an arm's length basis?
Yes. It is important to highlight that LRBAs which do not strictly comply with the ‘safe harbour' guidelines within PCG 2016/5 could still be considered to be on arm's length terms. That is, while SMSF trustees won't receive the certainty provided under PCG 2016/5, they will need to show in other ways that the LRBA was entered into and maintained on terms that are consistent with arm's length dealings. As stated by PCG 2016/5, one way of achieving 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'.
If the fund always stays within the ‘safe harbour' guidelines, does that mean the NALI provisions can never be triggered?
No. The ‘safe harbour' guidelines relate to the requirements that the Commissioner considers necessary to maintain an LRBA on an ‘arm's length' basis. As previously mentioned, the NALI provisions can be triggered in several ways, other than due to the structuring of a LRBA.
Footnotes
1. Explanatory Memorandum, Superannuation Legislation Amendment Bill (No. 2) 1999 at paragraph 2.13.
2. Originally released in 2014 as ATOIDs 2014/39 and 2014/40.
Catherine Chivers is the manager, strategic advice, at Perpetual.
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