If the SMSF is borrowing to acquire an asset pursuant to a limited recourse borrowing arrangement from a related party, the loan must be on arm's-length basis.
Background
The Australian Taxation Office released 2 Interpretative Decisions, ATO ID 2015/27 (listed shares) and ATO ID 2015/28 (real property). These Interpretative Decisions deal with non-arm’s length income when there is related party non-commercial limited recourse borrowing arrangement to acquire the asset.
The ATO's view is that those income of a SMSF derived under a non-commercial limited recourse borrowing arrangement will be subject to the non-arm's length income (NALI) pursuant to section 295-550 of the Income Tax Assessment Act 1997 (ITAA97). NALI is taxed at the highest marginal rate regardless of whether the SMSF is in accumulation phase (normal accumulation phase rate of tax is 15%) or retirement phase (normal retirement phase rate of tax is 0% up to the transfer balance cap amount).
The Interpretative Decisions provided indicia of what would constitute a non-arm's length arrangement, which included:
The question that needs to be asked is "Can the SMSF get the same deal in the open market?"
The proposed terms of a related party limited recourse loan must be compared against a loan that a lender (bank or finance company) would make to the SMSF in the same circumstances.
It is strongly recommended that the trustees obtain a written statement of loan terms from the bank or finance company - even if there is no intention of borrowing from the bank or finance company - and retain as evidence that the related party loan was on arm's length terms that replicate the terms the bank or finance company was offering the SMSF.
The safe harbour alternative
Instead of testing the market for a loan, the SMSF trustee may rely on safe harbour terms that are acceptable to the ATO.
ATO Practical Compliance Guidelines PCG 2016/5 sets out guidelines of the terms on which SMSF trustees may structure their LRBA with related party loan that are acceptable to the ATO. The structuring of the related party loan in accordance with the guidelines will mean that the ATO will accept that the non-arms length income provisions do not apply.
Safe harbour terms for real property. The safe harbour applies for both residential and commercial property.
| Interest Rate | Reserve Bank of Australia Indicator Lending Rates for banks providing standard variable housing loans for investors. Applicable rates: |
| Fixed / variable | Interest rate may be variable or fixed.
The fixed rate is the rate published for May (the rate for the month of May immediately before the relevant financial year). |
| Term of the loan | Variable interest rate loan (original) - 15 year maximum loan term (for both residential and commercial). Variable interest rate loan (re-financing) - maximum loan term is 15 years less the duration(s) of any previous loan(s) relating to the asset (for both residential and commercial). Fixed interest rate loan - a new LRBA commencing after publication of these guidelines may involve a loan with a fixed interest rate set at the beginning of the arrangement. The rate may be fixed for a maximum period of 5 years and must convert to a variable interest rate loan at the end of the nominated period. The total loan term cannot exceed 15 years. |
| Loan to Market Value Ratio (LVR) | Maximum 70% LVR for both commercial and residential property If more than one loan is taken out to acquire (or refinance) the asset, the total amount of all those loans must not exceed 70% LVR. The market value of the asset is to be established when the loan (original or re-financing) is entered into. |
| Security | A registered mortgage over the property is required. |
| Personal guarantee | Not required. |
| Nature & frequency of repayments | Each repayment is of both principal and interest. Repayments are monthly. |
| Loan agreement | A written and executed loan agreement is required. |
All existing arrangements must also comply with all the above terms for safe harbour to apply. If you have an existing arrangement where the related party loan arrangement departs from the safe harbour terms, the trustee will need to be able to demonstrate that the arrangement is on terms consistent with an arm's length basis.
Superannuation Accounting Services can provide you with advice and help you with documentation, including bare trust, loan agreement that meets the requirements, working with you on LVR, interest rates, and assisting with registration a mortgage on title.
Reference materials
ATO ID 2015/28
ATO ID 2015/27
ATO PCG 2016/5
