When a Self-Managed Superannuation Fund (SMSF) acquires an asset under a Limited Recourse Borrowing Arrangement (LRBA), if you don’t get your paperwork right, the income from the use of that asset may be taxed at 45% rather than the 15% payable by super funds.
Where there is an LRBA, the terms of the loan must be commercial and consistent with an arm’s length dealings. Often a related party loans money to a super fund to provide the deposit for a property purchase or to fill the gap in the Loan to Value Ratio (LVR) that the banks won’t cover. Often when these loans are made the paperwork is neglected, under the Aussie ethos of ‘she’ll be right mate – we’ll get around to it”. Less often, cunning taxpayers use the opportunity to manipulate what goes in and out of the fund by the fixing of either very onerous rates (effectively draining cash out of the fund) or very favourable interest rates paid by the fund (effectively increasing the value of the fund).
If these loan terms are not considered commercial, the ‘non-arm’s length income’ provisions in the tax legislation may apply which basically denies the trustees the concessional that allows the income from the asset to be taxed at 15%, by default this income becomes taxable at 45%.
“Safe Harbour” guidelines – Meet the guidelines and avoid the ATO audit
The ATO has released the Practical Compliance Guidelines (PCG) 2016/5 which if followed establishes a safe-harbour for these loans; basically, follow these guidelines and you won’t get into trouble.
The trustee may choose to argue that the current terms of the related-party loan are on a commercial footing, assuming that they can support that argument by independent benchmarking data. Alternatively, the trustee may choose to refinance the loan with a commercial lender or dispose of the asset.
Most trustees will wish to take the first option by ensuring that their SMSF is operating within the safe harbour guidelines. Trustees need to assess the different components of their borrowing arrangement and determine which, if any, need fixing. Loans on a commercial basis must have documents that deal with the following:• loan agreement;• interest rate;• interest terms;• duration of loan;• loan repayment requirements;• loan to value ratio (LVR);• security provided;• 2015/16 ‘catch up’.
Actions may include the following:Loan agreementThe loan agreement must be written and executed (including dated).
Action: If any changes are required as a result of the matters covered below, the action to be considered would include: • amend the loan agreement; or • refinance the loan to enable the introduction of a new loan agreement.Interest rateThe safe harbour rate, for real estate, is the RBA indicator Lending Rate for 2015/16 is 5.75 per cent. For listed shares or units, add 2 per cent (i.e. 7.75 per cent) To reach the safe harbour, the agreed rate, for all of 2015/16, would need to be the relevant amount above.Action: The loan agreement may need to be amended to reflect the ability of the lender to set that rate.Interest termsThe interest rate can be fixed or variable, with a limited time frame for a fixed rate arrangement. That time frame operates from commencement of the loan and is for 5 years (real estate) and 3 years (listed shares and units).Action: The loan agreement may need to be amended to change the fixed rate arrangement.Duration of loanUnder the safe harbour, the length of the loan is significantly shorter than what may be commercially available. For real estate, the maximum loan term (which includes the term of the original loan if refinancing), is 15 years and is 7 years for listed shares and units.Action: If the loan agreement states a longer term, it will need to be amended to shorten the term.Loan repayment requirementsInterest only terms are not available under the safe harbour.Action: The loan agreement may need to be amended to change the arrangement to principal and interest payments.LVRThe safe harbour LVRs are 70 per cent (real estate) and 50 per cent (listed shares and units). The calculation of the LVR, for 2015/16, is: Loan amount(s) 1 July 2015 + asset value 1 July 2015 Note: for multiple loans, the combined amount is used.Action: When the LVR is higher than the permitted ratio, the remedial action would likely be by reducing the principal of the loan, through: • using available cash in the fund; or • having members provide cash through contributions.Security providedSecurity under the safe harbour is a registered mortgage (real estate) and registered charge or mortgage over listed shares and units. Note the mortgage or charge must be registered. If there is no registered mortgage/charge, or a lesser form of security such as a caveat, that needs to be remedied.Action: Instructions from the SMSF trustee to the trustee of the bare trust, directing the latter to provide a mortgage/charge will be necessary. The lender should register the mortgage or charge. 2015-16 ‘catch up’.Finally, having put into effect all of the above remedial actions, transaction items need to reflect those changes from 1 July 2015. If all of the above matters are completed before 30 June 2016 (NOTE: NOW EXTENDED TO 31 JANUARY 2017), trustees can be satisfied that the 45% tax rate will not apply to this aspect of their fund. If SMSF trustees have entered into an arrangement which does not meet all of the Safe Harbour terms set out in the ATO guideline, it does not mean that the arrangement is deemed not to be on arms’ length terms. It merely means that there is no certainty, as is provided by the guidelines. The trustees will need to be able to demonstrate that the arrangement was entered into and maintained on terms consistent with an arms’ length dealing.If you or an associate has advanced funds under a LRBA to your fund, and the paperwork is not up to scratch, we can help you get your house in order. It’s not too late. Contact Noel May or Amanda Klye on 03 9585 7555 oremail us.