By Domenic Festa (Accredited Tax Specialist and Chartered Tax Adviser)
Effective Date: 6 September 2017
The rules for LRBA’s and superannuation funds do not prohibit the loan being made by related parties. A question that some ask is whether the interest rate could be zero. The attraction is obvious: the tax deduction for interest to the super fund is not more than 15%, with tax payable by the related party on the interest income often between 30% and the top marginal rate. In essence, charging interest on a loan to a superannuation fund will result in an additional amount of net tax payable.
Initially, the ATO gave a private ruling stating that the interest rate for an LRBA could be zero without being caught by the non-arm’s-length income provisions, but then reversed its position.
This led to calls for guidance from the ATO concerning the arm’s-length requirements of related party loans in an LRBA.
In Practical Compliance Guidelines PCG 2016/5, the ATO set out a safe harbour for LRBA’s (for real property, the requirements include an interest rate not less than the RBA indicator lending rate for standard variable housing loans for investors, a loan term not exceeding 15 years and refinancing does not refresh the loan term). In essence, this Guideline provides that a LRBA loan arrangement must fit within a safe harbour, be wound up by 30 June 2016 or the taxpayer has extrinsic evidence that the terms are consistent with an arm’s length dealing.
TD 2016/16 appears to take a different approach. It compares the terms of the LRBA loan in fact entered into with a hypothetical arm’s-length borrowing arrangement. If it is the case that the SMSF could not have or would not have entered into the hypothetical borrowing arrangement (because it had insufficient funds to meet the loan to value ratio, the investment was earnings accretive (taking into account income and capital gains) or for some other reason) then the whole of the income from the arrangement will be non-arm’s-length income and taxed at the top marginal rate.
What needs to be understood is that there are two core elements in determining whether a transaction is caught by the non-arm’s-length income provisions:
- A scheme the parties to which are not dealing with each other at arm’s length (the PCG is concerned with this element); and
- The income derived is more than might have been expected to have been derived if the parties were not dealing with each other at arm’s length (the Tax Determination is concerned with this element).
Even if it is the case that the SMSF is in a position where it could have and would have entered into the hypothetical borrowing arrangement, the TD notes that this does not necessarily mean the income is not caught. Rather, a comparison must then be made between the amount of income in fact derived and the amount of income that would have been derived under the hypothetical borrowing arrangement.
It should be noted that factors that the ATO will take into account in determining whether an SMSF “would have” entered into the hypothetical borrowing arrangement for an LRBA include where it is an optimal use of funds, whether the investment is consistent with its investment strategy, whether the investment is earnings accretive, as well as its capacity to meet the LVR ratio and the ongoing repayment obligations of the hypothetical borrowing arrangement. It can be expected that the ATO will make a comparison that results in a LRBA loan arrangement being caught unless it satisfies the Guidelines (including by having extrinsic evidence).
In the 2017/18 budget, the government announced would be amending the non-arm’s-length income provisions to ensure zero interest rate LRBA loans would be caught.
For those caught in an audit with the ATO, strong arguments can be put forward as to why the existing non-arm’s-length income provisions do not apply to LRBA loan arrangements.
We also have evidence from a leading lender that accommodates longer loan terms, interest only terms and longer fixed-rate terms, for those wishing to comply with the Guidelines by obtaining extrinsic evidence rather than complying with the safe harbours.
NOTE: This article is for general information only and should not be relied upon without first seeking advice from one of our specialist solicitors.