While borrowings from related parties have been around for some time, there have been a lot of discussions around what should be the appropriate terms for the arrangement.

The ATO has had concerns about related party LRBAs with less than commercial rates of interest for some time now. It issued TA 2008/5 as a result, since its concern was low interest rate, which could be characterized as a contribution. This position has since been revised in a National Tax Liaison Group (NTLG) meeting held in 2012, where in it was decided that discounted interest rate would not be treated as an increase in the fund, and hence a contribution.

What is NALI ?

The term NALI arises both in the SIS Act under section 109 and s295-550(5) of the Income Tax Assessment Act 1997 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. Trustees can derive great 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.

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 recent opinion outlined in ATO ID 2014/39 and ID 2014/40 published in December 2014. Both of them have now been withdrawn but they are still instructive in nature. In each case, the ATO went on to treat the incomes under both the cases as Non-arm’s length income (NALI) and taxed at 47%. For the facts please refer to the IDs. These determinations caused great concern among SMSF trustees with related party borrowings.

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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).

Till date, it is not a public ruling meaning that it is not binding. Primarily, it is designed as a “safe harbour protection” for SMSF trustees with related party loans under a Limited Recourse Borrowing Arrangement (LRBA).

The guidelines provide protection for trustees of SMSFs to ensure that their related party loan is treated as arms’ length, and any income from the asset is not to be treated under the non- arm’s length income (NALI) provisions.

It is explicit from the guidelines that if an arrangement is not consistent with the “safe harbour” terms as specified in the guidelines, it does not mean that the arrangement is automatically deemed as non commercial (Non-arms’ length). In that case, what actually happens is that the trustees will then have to demonstrate that the arrangement was entered into and maintained on terms consistent with arms’ length dealing.

The good news is that the ATO has extended the 30 June 2016 deadline for SMSF trustees with related party loans under a LRBA arrangement to ensure that the related party loan is on commercial terms or complies with the safe harbour guidelines to 31 January 2017. This means that the SMSF trustees with related party LRBA loan for the 2014/15 or earlier years have until the new deadline to ensure that their loans are on commercial terms.

How to Comply with PCG 2016 /5 

The guidelines also mention three methods that enable trustees to comply with the new rules:

• Ensure the terms and conditions are consistent with the safe harbour provisions;
• Re-finance the loan with a commercial financier; or
• Very unlikely, pay out the LRBA.

The safe harbour rules distinguish between real property and Listed shares/units in relation to application of the terms and conditions as detailed below:

Here interest rates may either be fixed or variable in nature. Moreover, the term of the loan is the remaining term of the loan calculated as a 15 year maximum period. For instance, if the original loan was taken on 1 July 2013 then the new terms of the loan on 1 July 2015 should be 13 and not 15 years to account for the two previous years of the loan being in existence.

Similarly, if refinanced through another loan agreement, the new term of the loan will be the maximum term being 15 years less the balance of expired years of the loan’s existence.

Practical problems in applying PCG 2016/5 rules

Some practical issues arise with the practical application of the guidelines. This is better illustrated with the help of an example from the PCG 2016/5:

A complying SMSF borrowed money under an LRBA on terms consistent with section 67A of the SISA. It used the funds to acquire commercial property valued at $500,000 on 1 July 2011. Let us assume that the lender here is a related party. The details of the arrangement are as below:

How to resolve various issues?

There is clarity in the guidelines that the market value of property as on 1 July 2015 may be used to determine the maximum loan amount. Based on 70% (LVR) of $643000 the maximum loan amount is $450100. The SMSF needs to repay $49900 as soon as practicable before 30 June 2016.

• Balance of maximum loan term is 11 years which is 15 years less the expired years of the loan.
• The interest rate of 5.75% p.a. applies from 1 July 2015 to 30 June 2016. The SMSF trustee must determine and pay the appropriate amount of principal and interest payable for the year. This calculation must take the opening balance of $500,000, the remaining term of 11 years, and the timing of the $49,900 capital repayment, into account.
• Further, the SMSF must review and amend the existing Loan agreement to incorporate the new terms and register a charge over the real property.

Problems which will continue to linger...

Some challenges for the trustees going forward relate to the maintenance of the low Loan to Value ratio (LVR) and loan repayments for 2015/16.

• Say, for instance, a property was purchased for $1 million and the related party loan was also $1 million on 1 July 2013 with 100% LVR.
• Subsequently, then, on 1 July 2015 the value of the property had increased to $1.1 million and only $20,000 was shaved off the loan which meant that remaining loan amount was $ 980,000 on that date.
• With a 70% LVR the amount of loan must now be reset to $770000 which means that $210000 (which is 980 less 770) must be repaid together with monthly EMI amounts of $8934 *12 (Principal plus interest) for 2015-16 which works out to $107,208.
• The total repayment then works out to $317,208(the $210,000 principal amount + the $107,208 interest payment for the year) which is indeed a very large sum. This brings us to the obvious question: does the SMSF have the cash to repay the debt? If not, the members of the SMSF must make sufficient contributions so to make the repayment possible.
• Alternatively, there may be a debt forgiveness of $230000 which would be treated as a contribution, as per ATO’s tax ruling TR 2010/1.
• Further, it must also be ensured that the non-concessional caps are not breached, and in certain cases, for example, when members are over 65 years and do not meet the “work’s test”, there is a real danger that this strategy might not work.
• A further challenge is the $500,000 lifetime Non-Concessional Cap which was announced by the government recently. 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 and to treat the same as NCC.
• 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 PCG 2016/5. This will come as a welcome relief for most trustees.
• And finally, it is also worth mentioning that 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 as outlined in the PCG.

Conclusion

There are several challenges in meeting the conditions as set in the guidelines. At the same time, there is clarity in what is actually a non- arm’s length loan for which one needs to be thankful.

The purpose of this article is to share an understanding of the new rules so that we can fix existing situations and devise new strategies for our clients going forward.

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