SMSFs with related-party limited recourse borrowing arrangements (LRBAs) have until 31 January 2017 to implement arm’s length terms for such arrangements.
The Tax Office considers that an amount of income derived by an SMSF, as a beneficiary of a LRBA custody trust under s 67A of the SIS Act, triggers the non-arm’s length income (NALI) provisions in the ITAA 1997 where the borrowing involves non-commercial terms.
ATO “safe harbour” terms
In Practical Compliance Guideline PCG 2016/5, the Tax Office granted a grace period to enable SMSF trustees with existing related-party LRBAs to take action to implement arm’s length terms by 31 January 2017 (or bring the LRBA to an end by that date).
The Tax Office will accept that a related-party LRBA is consistent with an arm’s length dealing, and the NALI provisions will not apply, if the loan meets the Commissioner’s “safe habour” terms in Practical Compliance Guideline PCG 2016/5. For example, the safe harbour rules for a real property LRBA require an interest rate of 5.75% for 2015-16 (5.65% for 2016-17), a maximum 70% LVR and a maximum term of 15 years. Importantly, arm’s length payments of principal and interest for 2015-16 must be made by 31 January 2017.
If an LRBA does not meet the safe harbour rules, the SMSF trustees will need to otherwise demonstrate that their arrangement is consistent with an arm’s length dealing. Where the parties to a LRBA are not at arm’s length, s 295-550(1)(b) of the ITAA 1997 requires a determination of the amount of income that the SMSF “might have been expected to derive” if the parties had been dealing with each other at arm’s length. Determination TD 2016/16 sets out the circumstances in which it would be reasonable to conclude that an SMSF trustee would not have entered into such a “hypothetical” borrowing arrangement with a related party on arm’s length terms.
The Tax Office also notes that a 2-step process is required when reviewing a SMSF related-party LRBA and, if necessary, amending its terms to ensure they are consistent with an arm’s length dealing. First, determine whether:
- the terms of the LRBA are consistent with the ATO safe harbours rules in PCG 2016/5; or
- the SMSF trustee can otherwise demonstrate that they are arm’s length.
If the answer is “yes”, then trustees do not have to consider Determination TD 2016/16 and are assured that the ATO will not seek to apply the NALI provisions on the basis of the borrowing terms under the arrangement.
The ATO says that the second step, requiring consideration of TD 2016/16, only comes into play if an SMSF has an LRBA on terms that are non-arm’s length. In this respect, TD 2016/16 is not an alternative to the safe harbours and only applies if borrowing terms of an LRBA are non-arm’s length.
An SMSF enters into a LRBA with a related-party to acquire commercial property. The loan terms include a $1m borrowing, 100% LVR, 0% interest rate, 25 year term and $0 monthly repayments.
Based on these facts, the Commissioner concluded in Determination TD 2016/16 that the SMSF would not have entered into an arm’s length hypothetical borrowing arrangement on those terms. The Commissioner noted that the SMSF did not have sufficient funds to reduce the level of borrowings to a maximum LVR of 70% under the safe harbour rules in PCG 2016/5. Taking into account the weekly rental of $1,000 and any future capital gains, the Tax Office also considered that the hypothetical scheme would not be “earnings accretive”. As such, the income that the SMSF would be expected to derive from the scheme if the parties were dealing with each other at arm’s length was “nil”. Therefore, the $1,000 per week rental income the SMSF received under the LRBA would be NALI (taxable at 47%).