ATO ready to audit SMSFs with LRBAs not financed by a bank

Immediate action to be taken by advisors and SMSF trustees

*** ON 31 May 2016, ATO has extended date to 31 January 2017 ***.

• ATO issued yesterday PCG 2016/5 (Guideline) to provide the ATO’s rules for non-bank LRBAs to be consistent with arm’s length dealing

• Commencing 1 July 2016, ATO will audit SMSFs with LRBAs not financed by a bank and do not meet the Guideline or terms consistent with arm’s length dealings

• Imperative that SMSF trustees and advisors place non-bank LRBAs on terms that meet the ATO’s Guidelines to avoid ATO audit risk

The ATO has provided ample warnings that it intends to commence audits on SMSFs with non-bank LRBAs from 1 July 2016.  In October last year and on 5 November 2015 at the Tax Institute’s National Tax Intensive Retreat,  Assistant Commissioner for Superannuation, Kasey Macfarlane announced that the ATO will allocate compliance resources to review SMSFs with related party or non-commercial loans (Non-Bank) LRBAs for the 2015-16 year and later years.  Ms MacFarlane confirmed that the ATO will potentially apply Non-Arm’s Length Income (NALI) to those SMSFs indefinitely unless the LRBAs are brought in line with the ATO’s requirements of an arm’s length arrangement on or before 30 June 2016. Ordinarily income of an SMSF is taxed at 15%, or 0% to the extent it is in pension phase, but NALI is currently taxed at 47%.

The ATO’s public position on NALI applying to LRBAs were originally set out in two Interpretive Decisions, ATO ID 2014/39 and ATO ID 2014/40. However, with the passing of the look-through tax treatment for LRBAs, these decisions have been withdrawn and two new ATO IDs issued:

• ATO ID 2015/27 Income tax: non arm’s length income – related party non-commercial limited recourse borrowing arrangement to acquire listed shares

• ATO ID 2015/28 Income tax: non arm’s length income – related party non-commercial limited recourse borrowing arrangement to acquire real property

The ATO in its publication entitled, “Non arm’s length limited recourse borrowing arrangement” issued in December 2015 to encourage SMSF trustees to review their LRBAs stated:

“We have on a number of occasions expressed our view that the… NALI provisions can apply when an SMSF trustee undertakes …LRBA established or maintained on terms that are not consistent with an arm’s length dealing…. SMSF trustees should review any LRBA you have to determine whether it was established and maintained on terms that are consistent with an arm’s length dealing. If this is not the case, we strongly encourage you to take steps to ensure that it is on terms consistent with an arm’s length dealing by 30 June 2016 or to bring the LRBA to an end by that date. You may wish to seek professional advice if you are unsure.”

Whilst we do not agree with all aspects of the ATO IDs issued by the ATO, we nevertheless welcome the benefit of certainty for taxpayers which arises from and the ‘safe harbour’ terms offered by the ATO’s release on 6 April 2016 of the Practical Compliance Guidelines, PCG 2016/5 entitled,  “Income tax – arm’s length terms for Limited Recourse Borrowing Arrangements (LRBA) established by Self-Managed Superannuation Funds (SMSF)” (Guideline).  The Guideline applies to LRBAs established (under section 67A and former section 67(4A) of the SIS Act) regardless of the date of the arrangements. The safe harbour terms are divided into two groups - one set for residential and commercial properties (including property used for primary production), and the other for collection of stock exchange listed shares or units.  The Guideline specifically do not cover LRBAs used to acquire unlisted or privately held shares or units. 

Broadly, the following table summarises the key terms of the safe harbour for the two groups in accordance with the Guideline:

The ATO accepts that SMSF trustees that structure LRBAs in accordance with the Guidelines by 30 June 2016 will be consistent with arm’s length dealing but it does not mean the NALI provisions do not apply for other reasons.  It is imperative that loans that do not satisfy one or more criterion are all amended to satisfy the Guideline on or before 30 June 2016.  The ATO recognises that more than two loans can be provided to an SMSF under an LRBA.  However, where the combined loans exceed the maximum LVR set out above, the terms of LRBA are not arms length and NALI may apply.

In addition, LRBAs that do not satisfy the Guideline, the ATO states “it does not mean that the arrangement is deemed not to be on arms’ length terms. It merely means that there is no certainty provided under this Guideline. The trustees will need to be able to otherwise demonstrate that the arrangement was entered into and maintained on terms consistent with an arms’ length dealing. For example… by maintaining evidence that shows their particular arrangement is established and maintained on terms that replicate the terms of a commercial loan that is available in the same circumstances.” SMSF trustees that established LRBAs funded by non-bank loans to acquire unlisted or privately held shares or units should review their documentary evidence and security including supporting valuations to satisfy the ATO that the terms of the LRBA are arm’s length.  Other options are set out below.

The ATO encourages SMSF trustees under its Guideline to avoid having to report NALI for the 2015-16 year (and prior years) to undertake one of the following options:

• Alter the terms of the loan to meet the guidelines.  The trustees of the SMSF must ensure all the terms set out in the above table are satisfied and continues to comply with the Guideline at all times.  For example, the interest rate used for the loan on 1 July each year (if variable) and make monthly principal and interest repayments accordingly.

• Refinance through a commercial lender which involves extinguishing the original arrangement and paying the associated costs. 

• Pay out the LRBA and bring the LRBA to an end before 30 June 2016. The payments of principal and interest made must be consistent with an arm’s length dealing under the terms of the LRBA.

Under all the above options, the SMSF trustees must ensure the relevant amount of principal and interest are paid to the original lender for the 2015-16 income year.

Risks and action to be taken by SMSF trustees and their advisors immediately

• LRBAs with loans from non-banks must satisfy the Guideline and/or satisfy arm’s length terms on or before 30 June 2016.

• LRBAs on terms that are consistent with the Guideline and/or arm’s length dealing must make payment of principal and interest for the year ended 30 June 2016.

• NALI can apply when SMSF trustees establish or maintain LRBAs that are not consistent with terms under the Guideline and not arm’s length by 30 June 2016.

• Where NALI applies, 47% tax is applicable to the SMSF and cannot be rectified after 1 July 2016.

How we can help

• We can assist with preparation of documentation to comply with the Guideline which must be entered prior to 30 June 2016.

• Our firm’s LRBA documentation are consistent with the Guideline (and Division 7A where necessary) for all new LRBAs.

• We can provide specific advice to SMSF trustees and advisors that are unable to meet the 30 June deadline or LRBAs which fall outside the Guideline. This may involve us taking a special approach with the ATO on your behalf.

Author: Lisa To