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By Mark Ellem

Article update! - ATO announces extension to 31 January 2017 for LRBA related party loan compliance (Monday, 30 May 2016)

The ATO has extended the 30 June 2016 deadline for SMSF trustees that have a related party loan under an LRBA to ensure that the related party loan is on commercial terms or complies with the safe harbour guidelines. The deadline has been extended to 31 January 2017.

This extended deadline means that the ATO will not select an SMSF for a review purely based on it having an LRBA for the 2014/15 or earlier year, provided the related party loan is on commercial terms or the LRBA is brought to an end, by 31 January 2017. It also requires the SMSF to make loan repayments of principal and interest for the year ended 30 June 2016, based on commercial terms, by 31 January 2017.

Original article now follows:

You are no doubt aware of the ATO’s recently released Practical Compliance Guidelines on how to ensure a related party loan in a Limited Recourse Borrowing Arrangement (LRBA) is treated as commercial, known as the ‘safe harbour guidelines’ (PCG 2016/5). Given that these types of loans must be made commercial for the 2015/16 financial year to ensure no compliance action by the ATO, it is urgent that you review any of your SMSF clients that have these arrangements and take appropriate action by 30 June 2016.

These guidelines come after several months of consultation with the SMSF industry to create a practical solution to ATO interpretive decisions raised in December 2014 that result in non-arm’s length income (NALI) tax rates (currently 47%) being applied to earnings if the loan terms are not commercial.

The urgency on this matter is due to the ATO announcement in October 2015 that no action will be taken in respect of related party loans that were not commercial if they are made commercial for the 2015/16 financial year.

So what needs to be done by 30 June 2016?

Under these guidelines there are two methods for meeting these requirements:

1. Ensure your terms and conditions of the loan align with the safe harbour guidelines; OR
2. Re-finance the loan with a commercial financier.

The ‘safe harbour’ guidelines do have different terms depending on the nature of the asset being acquired under the LRBA. It is interesting to note that the guidelines only deal with real property and listed shares or listed units in a unit trust and no other type of asset. This would mean that for an LRBA, where the underlying asset was, for example, shares/units held in a non-geared company/unit trust, (also known as a SIS regulation 13.22C entity), the ‘safe harbour’ guidelines could not be used. Further, these terms, outlined below, must be contained in a written executed loan agreement.

Some key factors from the above table are:

• The interest rate, which is based upon the RBA standard variable investor loan, is the rate announced for the month of May each year and should be used from the following 1 July;
• The interest rate does not have to be changed, except each July, the start of the new income year. However, see next point;
• The interest rate can be fixed, but only for 5 years where the asset under the LRBA is property and 3 years for listed shares or units in a fixed trust;
• The remaining term of the loan is calculated from the commencement of the related loan, not 1 July 2015;
• If the loan is re-financed with another related party loan then the term of the re-financed loan must take into account the term of the original loan. For example, a related party loan commenced 1 July 2011 and is re-financed on 1 July 2016 with a new related party loan. The asset acquired with the original loan monies was real property. The maximum term of the re-financed related party loan is 10 years, which would be the same remaining term if the original loan was not re-financed, but simply amended to the ‘safe harbour’ guidelines. Re-financing to another related party loan does not re-start the term;
• The LVR of 70% for real property LRBAs and 50% for listed shares or units LRBAs is an aggregate for all related party loans;
• The ‘safe harbour’ guidelines require the LVR to be determined as the start of the related party loan. However, for an LRBA with a related party loan in existence at the time of publication of the ‘safe harbour’ guidelines, the 1 July 2015 market value of the asset under the LRBA may be used;
• Repayments must be on a principal and interest basis. To comply with these safe harbour guidelines, there can be no interest only loans;
• Repayments must be made on a monthly basis, not any other basis, e.g. quarterly;
• To satisfy the requirement for loan to be secured, for non-property arrangements, use the Personal Property Securities Register.

It is also worthwhile to note that compliance with the ‘safe harbour’ guidelines is not mandatory. If the trustee(s) of an SMSF decide not to comply with these guidelines it does not mean that the LRBA will be subject to the NALI rules. However, to demonstrate your arrangement is commercial and consequently the income from the LRBA not treated as NALI, what you will need to have is documentary evidence that related party loan’s terms and conditions are the same as those available from a commercial financier.

It was reported in SMSF Adviser online (Friday, 22 April 2016 “ATO sets record straight on LRBA panic”) that Kasey Macfarlane, ATO assistant commissioner, said, on this particular issue:

“The safe harbours and the PCG itself… don’t set a minimum benchmark that all LRBAs have to comply with,” she told SMSF Adviser.

“It is a safety net, if you like, so if SMSF trustees choose to apply it they can have certainty that the non-arm’s length income (NALI) provisions won’t apply to their particular arrangement if the structure is within those parameters.

If they choose not to apply the guidelines, and they have an arrangement that is structured outside of the parameters of the guideline – that doesn’t mean that automatically the NALI provisions apply. It just means that they don’t have the certainty of that safety net… and they just need to be able to demonstrate that their arrangement nevertheless is consistent with a commercial dealing.”

Can the SMSF make the relevant payments by 30 June 2016?

If an SMSF with a related party loan under an LRBA wishes to be protected by the ‘safe harbour’ guidelines, then the two requirements which will be most difficult to comply with, given the short time remaining, will be:

• Loan to value ratio (LVR); &
• Commercial loan payments for 2015/16.

By 30 June 2016 the LVR must be no more than 70% where the assets held under the LRBA is property and 50% where the asset is listed shares or units in a fixed trust. This may require a large amount of the loan to be paid by 30 June 2016. Consider an LRBA, acquiring a real property asset on 1 July 2011 for $700,000 with a related party (non-recourse) loan of $700,000, that is, a 100% LVR. Let’s say that the property is now valued at $750,000. Under the ‘safe harbour’ guidelines the LVR can be no more than 70%, meaning the loan must be no more than $525,000 and the SMSF must repay $175,000 on the loan by 30 June 2016. Does the SMSF have the cash to do this? If not, are the members of the SMSF in a position to make sufficient contributions so the SMSF can make the repayment? An alternative would be for there to be a debt forgiveness of $175,000, which would be treated as a contribution, per the ATO’s tax ruling TR 2010/1. You would need to ensure that the debt forgiveness did not exceed the relevant contribution caps (where the lender to the SMSF is a member of the fund, then the non-concessional caps and even the bring forward rule could be utilised).

However, this is on the assumption that the lender to the SMSF is a member of the fund. What if the lender was a related entity? A debt forgiveness would still be treated as a contribution, however, as it would not be by an individual, would most likely be regarded as a concessional contribution and not only come under the much lower concessional contribution cap, but also be treated as an assessable contribution.

Even where the lender to the SMSF is a member of the fund, if they are over 65 and do not meet the ‘work test’ or are over age 75, a debt forgiveness strategy would simply not work.

Not only do the terms of the loan have to comply with the ‘safe harbour’ guidelines by 30 June 2016, but the repayments made for the entire 2015/16 income year must be commercial. Calculation will need to be done to determine what loan repayments should have been made in 2015/16, what actually has been made and the shortfall paid by 30 June 2016. Another strain on the SMSF’s cash flow or on the members’ contribution caps.

Example from PCG 2016/5

A complying SMSF borrowed money under an LRBA on terms consistent with section 67A of SISA. It used the funds to acquire commercial property valued at $500,000 on 1 July 2011.

The following table shows the original LRBA and loan as compared to the details of the loan and “catch up” payments required to comply with the ‘safe harbour’ provisions.

Notes:

1. The Guideline allows market value of property at 1 July 2015 to be used to determine maximum loan amount as at 1 July 2016;
2. 70% of $643,000 and maximum loan balance allowed. This will require a capital repayment of $49,900 as soon as practicable, but no later than 30 June 2016;
3. Balance of maximum term loan of 15 years remaining as at 1 July 2015 is 11 years;
4. The amount of P & I loan payable for 2015/16 must take the opening balance of $500,000, the remaining term of 11 years and the timing of the $49,900 capital repayment into account. Assuming the $49,900 capital repayment is made on 30 June 2016, the monthly P & I loan repayments required to be paid for 2015/16 is calculated as $5,120 per month, totalling $61,440 for 2015/16, including interest of $27,875.Taking into consideration the capital repayment of $49,900 to reduce the LVR to 70%, based on the 1 July 2015 market value, the related party loan balance as at 1 July 2016 would be $416,535. Assuming an interest rate of 5.75% (noting that this may change depending on whether the RBA rate for standard variable housing loans for investor changes in May 2016 or if the loan has been fixed for 5 years) and with a remaining term of 10 years, the new monthly loan repayments, from July 2016, would be calculated as $4,572.

Further, in addition to the payment of $49,900 (LVR capital repayment) and $61,440 (P&I loan repayments) to be made by 30 June 2016, the following actions are required to satisfy the ‘safe harbour’ provisions:

• Amend the existing loan agreement. This would require reviewing the existing loan agreement to ascertain how it can be amended. You also may need to engage the services of a lawyer to both review and amend the existing loan agreement;
• Register a charge over the real property; &
• Implement the new monthly P&I loan payments for 2016/17.

Actions by 30 June 2016

All existing LRBAs with a related party loan should be reviewed and either:

Option 1 – Comply with the ATO’s ‘safe harbour‘ guidelines for the 2015/16 financial year. Compliance will ensure that previous years will not be assessed as NALI;

Option 2 – Ensure 2015/16 repayments meet the ATO’s ‘safe harbour’ guidelines and refinance with a commercial lender;

Option 3 – Repay the related party loan in full. However, this will still require that 2015/16 repayments meet the ATO’s ‘safe harbour’ guidelines

Option 4 – Have documentary evidence that the LRBA related party loan terms are equivalent to a commercial lender’s terms. However, this option will not result in automatic compliance and protection from the NALI rules.

How will the ATO know?

The ATO will only have to wait for the 2015/16 SMSF annual returns to be lodged to be able to monitor and determine if an SMSF has a related party loan under an LRBA with non-commercial terms. The labels within the SMSF annual return will provide a good indicator as to whether the loan terms are commercial, specifically:

Section C 12 – Labels A1 & A2 – Interest expenses within Australia

Section C 12 – Labels B1 & B2 – Interest expenses overseas

Section H 15b – Labels J1 – J6 – Asset types bought under LRBAs

Section H 16 – Label V – Amount of borrowings

This data will allow the ATO to measure the LVR and estimate the interest rate and based on these calculations, additional information may be sought from the SMSF to verify commercial terms.