SMSF Borrowing – New Safe Harbour Guidelines & deadline for borrowing arrangements to be made arms length
From time to time the ATO issues Practical Compliance Guidelines (“PCG”) which are designed to provide taxpayers an idea of where the safe harbours are in the sometimes murky waters of taxation compliance.
The most recent PCG issued was PCG 2016/5 “Income tax – arm’s length terms for Limited Recourse Borrowing Arrangements established by self managed superannuation funds” (“the ATO Guideline”).
Limited Recourse Borrowing Arrangements (“LRBAs”) are an exception to the general rule that prohibits self managed superannuation funds (“SMSFs”) from borrowing. In summary an LRBA is one where an SMSF can borrow to buy certain investments where the property is held in a bare trust structure and the recourse that the lender has is limited to the property the borrowing is for. Usually the lender is a bank however there is nothing to prevent the lender being a related party such as a member of the fund. There has been a concern in the industry that the LRBAs have been used inappropriately in that they would otherwise breach the prohibition against Non-arm’s length income. Non arm’s length income (or NALI) is income that is received which is not on terms what would be received by a bona fide investor dealing with an unrelated party, in other words, arm’s length income. An example of what would probably be considered NALI would be a lender lending on terms where the interest rate is 0%.
The ATO Guideline has been designed to address the above concerns so taxpayers have some comfort in using LRBAs but also allow the ATO to direct their resources at pursuing those LRBAs which don’t comply rather than the majority of SMSFs which are good operators. They are also designed to be means of encouraging those older LRBAs to restructure so that they do comply. It is not mandatory to comply with the ATO Guideline however if you do not you need to ensure that you have sufficient evidence to convince the ATO that the income received should not be treated as NALI.
The PCG are NOT expressions of law. Compliance with the guidelines does not mean that you are not in breach of the law and potentially subject to penalties. What they are is an indication from the ATO that if taxpayers do not adopt practices which comply with the guidelines then there is a possibility that they will be subjected to the greater scrutiny of the Tax Office. PCGs are designed to give the taxpayer an indication of what behaviours will generally be acceptable but also allow the ATO to direct their resources to investigating those taxpayers operating in the fringe of compliance with the law.
1. If an SMSF has an LRBA which is structured in accordance with the Guideline the ATO will accept that the terms are consistent with an arm’s length dealing and the NALI provisions will not apply purely because of the terms of the borrowing arrangement.
2. Only apply to LRBAs where the asset acquired is real property (such as a residential or business property) or a collection of publicly listed shares or units. The ATO Guideline does not therefore cover the field.
3. For real property the ATO will deem that the borrowing is consistent with an arms length dealing if the terms of LRBA contain:
a. An interest rate equal to the Reserve Bank indicator lending rate for banks. For the financial year 2015-2016 the rate is 5.75% The rate is then published in May each following financial year;
b. Interest rates can be fixed or variable however if the rate is fixed the maximum period is 5 years;
c. The maximum period of the loan (including any refinancing and years already served on an existing LRBA) must not exceed 15 years;
d. The maximum Loan to Value Ratio (LVR) for commercial or residential property is 70%. This will end the 100% loan arrangements which were anecdotally being used;
e. The repayments of the loan must be for principal and interest and are required monthly; and
f. A registered mortgage and a written and executed loan agreement is required;
4. For listed shares:
a. The interest rate must be 2% more than the rate for real property (i.e. 7.75%)
b. Interest can be fixed or variable but any fixed period must not be more than 3 years;
c. The maximum period of the loan (including any refinancing) must not be more than 7 years;
d. The maximum LVR is 50%;
e. There must be a registered charge, mortgage or similar security in place;
f. Repayments must be for principal and interest and be paid monthly; and
g. There must be a written and executed loan agreement in place.
5. In both circumstances personal guarantees are not required.
What you should do if you have an existing Limited Recourse Borrowing Arrangement which does NOT comply with the ATO Guideline?
You do not have to do anything. The ATO Guideline is not mandatory or automatically mean that you are in breach of the law. However if you do not satisfy the ATO Guideline the ATO will likely scrutinize the terms of the LRBA. It may be that you have sufficient evidence to show that notwithstanding that it does not comply with the ATO Guideline the income should not be treated as NALI. For example, you might have evidence showing that the interest rate you would have got from a bank for that particular investment would have been higher or lower than the guideline rate.
If however the ATO treats the income received via the LRBA as NALI it will be taxed at the top marginal rate which is currently 47% rather than the concessional rate of 15% or 0% if the fund is in the pension phase. Not complying with the ATO Guideline is therefore a risky proposition.
The ATO Guideline does not include grandfathering provisions. That is, the ATO Guideline applys to all current as well as future LRBAs. The ATO has however provided a small grace period that expires on 30 June 2016 to bring all existing LRBAs onto an arm’s length basis. After that date all bets are off and the ATO will apply the ATO Guideline.
The options available are:
1. Amend the terms of the LRBA to bring the terms within the ATO Guideline;
2. Pay out the loan and bring the LRBA to an end; or
3. Refinance the loan with a bank or commercial lender
For some SMSFs there may be no option but to sell the investment related to the LRBA if it is viable to adopt any of the three options listed above. This may see the SMSF incurring additional costs and capital gains tax as a result.
If you have an SMSF with an LRBA or are an advisor with SMSF clients you should contact us immediately to review the terms of your loan arrangement to advise whether it complies with the ATO Guideline and, if you decide to bring your SMSF within the terms of the ATO Guideline, assist you in that process.
We are offering a special deal of $550 to review your existing LRBA documents to advise if they comply with the ATO Guideline to all existing or new clients that contact us before 24 June 2016. As part of that advice we will provide recommendations of what steps need to be taken to bring the SMSF into compliance with the ATO Guideline and provide referrals to appropriately experienced financial advisors, mortgage brokers or real estate agents that can also assist you if necessary.
It will be 1 July 2016 before you know it – you don’t want to find yourself outside of the safe harbor unless you are prepared to risk the rocky shoals of NALI.
Farrar Gesini Dunn
12 April 2016
Farrar Gesini Dunn – Canberra office