In early April of this year, the ATO issued a Practical Compliance Guideline, PCG 2016/5. The guideline deals with related party loans under a limited recourse borrowing arrangement (LRBA). The guideline outlines the “safe harbour” terms that SMSF Trustees may follow in structuring an arm’s length related party loan under a LRBA before 30 June 2016.
The concerns with LRBA with a related party loan have arisen mainly due to the terms of these arrangements not being similar to those on a commercial footing, i.e. a SMSF may have established a LRBA with a nil interest rate and the principal to be repaid back in 20 years time.
The creation of these terms on a non arm’s length have given the ATO much thought as to whether the income earned from the asset (purchased under the borrowing) should be classified as non arm’s length income (NALI).
Although the ATO initially accepted such arrangements, in October 2015 the ATO issued ID 2015/27 and 2015/28. As noted in Heffron Super News these interpretive decisions mean that, it is now possible for NALI to arise from the asset of a LRBA if the arrangements were not held to be on commercial terms.
PCG 2016/5 provides SMSF trustees with a guideline as to the terms that are expected to be held within a LRBA on an arm’s length basis. If these terms are met before 30 June 2016, then the NALI provisions do not apply.
The guideline deals with only property, including residential, commercial and primary production activities and listed shares and listed units.
The following guideline terms relate solely to the acquisition of property under a LRBA:
For the 2015/2016 financial year the interest rate is 5.75%. This rate is published each May and applies to the forthcoming financial year.
The interest rate may be variable as per the rate indicative for that financial year or it can be fixed for a maximum of 5 years based on the rate at the commencement of the arrangement.
Term of Loan
The maximum term of a variable loan is 15 years. This also applies to a fixed loan however the loan must revert to a variable loan after a fixed period of five years. Note, that if the LRBA has been in existence before the publication of the guideline then the maximum term of 15 years is reduced by that period.
Loan to Market Value Ratio (LVR)
The LVR for both residential and commercial property cannot exceed 70% of the market value of that property as at 1 July 2015. Where more than one LRBA has been taken out to acquire a property, the combined total of those loans must also not exceed 70% of the LVR.
A registered mortgage over the property is required. This may be an issue where more than one LRBA has been taken out, particularly when that loan is with a bank. According to Partners Wealth Group recent newsletter, where a bank will not accept a second mortgage on the property, then the related party loan will need to be repaid in full. If this cannot be done, then the debt will have to be converted to non-concessional contributions.
No personal guarantee is required.
Nature & frequency of repayments
Loan repayments need to be monthly which includes principal and interest.
A written and executed loan agreement is required.
What to do
The ATO has given SMSF trustees until 30 June 2016, 3 options in dealing with their non arm’s length LRBA:
1. Alter the terms of the loan to meet the guidelines;
2. Refinance the loan through a commercial lender; and
3. Pay out the loan.
Note, that where the LRBA is refinanced during the 2015/2016 financial year, the original LRBA will need to reflect it is still consistent with an arm’s length dealing, i.e. loan repayments are made for principal and interest.
By meeting the terms of the guideline the ATO will accept the LRBA to be consistent with an arm’s length dealing.
The failure to comply with all of the terms of the guideline by 30 June 2016 may result in the ATO determining that the LRBA is not at arm’s length and therefore subject to the NALI provisions. The consequence of the NALI provisions are that all income from the asset (purchased under the borrowing) will be taxed at the highest marginal tax rate, currently 49%. This also includes any capital gain that may be realised on the asset even when the fund may be in pension phase.
Where the terms of the LRBA differ from the guideline, it will be up to the trustees to demonstrate that the terms of the arrangement replicate the terms of a commercial loan that is available in the same circumstances.
SMSF trustees should also be aware that the ATO will be conducting income tax reviews on SMSF’s for the 2014/2015 year or earlier years where the LRBA has not meet the safe harbour terms by 30 June 2016.
SMSF trustees who are concerned with meeting the above requirements before 30 June 2016 should contact the ATO to discuss their particular circumstances.
It is important that all LRBA’s with a related party loan are reviewed now and that any measures that need to be put in place are done so by 30 June 2016.
LRBA’s that have been set up to purchase assets other than property, listed shares and listed units i.e. units in a related /unrelated unit trust should also be reviewed.
Reference to the PCG 2016/5 guideline should be made to future LRBA’s when establishing a related party loan for the purchase of property or listed shares and listed units.
May 2016 ~ Fabio Salvatore, Concise Super
© Concise Super 2016