April 2016: Related party borrowing and SMSFs – the ATO’s “safe harbour” guidelines in PCG 2016/5
BORROWING IN SUPER: INTRODUCTION & BACKGROUND
Borrowing within superannuation funds has become increasingly popular amongst high net worth individuals with self-managed superannuation funds (SMSFs) and are permitted provided the limited recourse borrowing arrangement rules under superannuation law are complied with. In summary, a lender is able to lend to an SMSF provided that the lender’s recourse is limited to the asset being acquired and the asset in question is held by a separate custodian trustee on trust for the SMSF trustee for the duration of the loan. At law, members (or other related parties) are not prohibited from lending to an SMSF, provided the loans are properly documented and comply with superannuation and tax law.
The Australian Taxation Office (ATO) previously released ATO ID 2015/27 and ATO ID 2015/28 which provided their views that interest-free loans to SMSFs by related parties gave rise to non-arms’ length income (NALI) which would have adverse taxation implications for the SMSF.
Where a superannuation fund (including SMSFs) has NALI, such income (and potentially capital gains, if the underlying asset is sold) is taxed at the highest marginal tax rate and is still taxable at this rate even if the members are in pension phase. The ATO’s comments in the above ATO IDs alerted advisors to amend their LRBA documents to more commercial rates. The problem was that there was no guidance on what the ATO considered to be arm’s length terms.
In December 2015, the ATO released commentary on their website which provided a temporary “amnesty” allowing trustees to review their LRBA terms and noted that they will not be selecting SMSFs for review for the 2014-15 financial year or earlier years purely because the fund had entered into an LRBA. They encouraged all SMSF trustees to ensure that their related party LRBAs were on arms’ length terms before 30 June 2016 though, and indicated that they may allocate resources to review LRBAs for the 2015-16 or later financial years.
On 6 April 2016, the ATO released Practical Compliance Guidelines PCG 2016/5 (the Guideline) which provided “safe harbour” thresholds and guidelines for related party LRBAs. Generally speaking, if such thresholds are followed when implementing a related party LRBA, trustees of SMSFs can be provided certainty that the NALI provisions would not apply purely because of the terms of the LRBA.
SAFE HARBOUR TERMS
We recommend that all advisors and clients read PCG 2016/5 in its entirety and familiarise themselves with the Guideline as urgent action may need to be taken to ensure that an LRBA is on arm’s length terms prior to 30 June 2016.
A summary of the safe harbour thresholds is listed below and the full text of the Guideline is available on the ATO’s website.
|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: For the 2015–16 year, the rate is 5.75% For the 2016–17 and later years, the rate published for May (the rate for the month of May immediately prior to the start of the relevant financial year)||Same as real property + 2% For the 2015–16 year, the rate is 7.75% For the 2016–17 and later years, the rate published for May (the rate for the month of May immediately prior to the start of the relevant financial year) + 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), eg a PPSR security interest|
|Personal guarantee||Not required||Not required|
|Nature and frequency of repayments||Monthly repayments on a ‘principal and interest’ basis||Monthly repayments on a ‘principal and interest’ basis|
|Loan agreements||Written and executed||Written and executed|
The ATO also provides its comments on the use of variable and fixed interest rates in the Guideline and confirms that the trustee is able to fix the rate at the commencement of the arrangement for a specified period, up to a maximum of 5 years for real estate or 3 years for listed securities.
BACK TO BACK LOANS AND SAFE HARBOUR THRESHOLDS
A common strategy amongst advisors was to implement “back to back loans”, which involved an individual in their personal (or other) capacity borrowing funds from a commercial lender on commercial terms with security being provided outside their SMSF. Those funds would then be on-lent to the SMSF trustee at the same interest rate and principal repayment terms. In light of the recent Guidelines, the interest rate under the back to back loan is likely to be below the interest rates under the safe harbour thresholds.
In the Guideline, the ATO has noted that an LRBA does not automatically fail the arm’s length dealing test for NALI purposes if the LRBA does not meet all the safe harbour thresholds, but rather, the taxpayer would not have any certainty under the Guideline. In those circumstances, the ATO notes that the SMSF trustee will need to demonstrate that their arrangement was in fact “entered into and maintained on terms consistent with an arms’ length dealing”. For instance, a trustee could show that their arrangement replicated the terms of a commercial loan available directly to the SMSF trustee in the same circumstances.
Where back to back loans have been implemented, the trustee should seek confirmation from the commercial lender on what its lending terms would have been had an equivalent amount been lent directly to the SMSF trustee (eg, interest rate, loan to value ratio, nature and frequency of repayments and duration of the loan). The same approach could be taken before a loan is implemented if clients and their advisors are considering implementing a back to back loan in the future.
The Guideline provides several options which can be implemented by 30 June 2016:
- Option 1: amending the terms of the LRBA by 30 June 2016 to ensure that the terms are within the safe harbour thresholds;
- Option 2: refinancing the loan with a commercial lender by 30 June 2016; or
- Option 3: bringing the LRBA to an end and winding it up by 30 June 2016.
Another practical option for back to back loans is to ensure that SMSF trustees have evidence to confirm that their LRBAs were entered into and maintained on terms consistent with an arms’ length dealing, despite not meeting the safe harbour thresholds.
The 30 June 2016 deadline is fast approaching and urgent action may need to be taken to minimise adverse tax consequences. Clients and their advisors should ensure that the appropriate steps are undertaken ahead of time. If the deadline cannot be met, a submission to the ATO may be required.
Any questions, please contact Nathan Yii on 03 8658 5898 or email email@example.com.
DISCLAIMER: This newsletter is prepared for training, educational & general information purposes only & should not be relied on as (or in substitution for) legal, accounting, financial or other professional advice.