I have a solution! (Naturally, this solution is subject to an important disclaimer below.)

Background

Late last year, the ATO released two interpretive decisions of what not to do: ATO ID 2014/39 and ATO ID 2014/40. The SMSFs in both of these ATO IDs ended up with non-arm’s length income (NALI).

The ATO then clarified on their website:

To be able to demonstrate that NALI does not arise, a fund trustee entering into an LRBA with a related-party borrower should obtain and keep documentation that enables them to establish that the terms of the loan, taken together, and the ongoing operation of the loan are consistent with what an arm’s length lender dealing at arm’s length would accept in relation to the particular borrowing by the fund trustee.

In short, the ATO seem to want benchmarking. Naturally, this makes sense.

The gold standard no doubt is to go to a bank — or even a number of banks — and get a written quote for the interest rates, loan-to-value ratio and other terms that the bank would use when lending. Then, ideally, one should replicate those terms in the related-party loan.

However, there are certain instances where banks simply won’t lend to an SMSF. This is not because it is prohibited for SMSFs to borrow in such circumstances; rather, it seems to be more to do with banks’ conservative policies.

Two common situations are as follows:

Scenario 1: where the SMSF will use the borrowed money to acquire a tenants in common interest in real estate.

Scenario 2: where the SMSF will use the borrowed money to acquire units in a reg 13.22C unit trust.

(For completeness, I do acknowledge that sometimes a bank will lend in these circumstances. However, that is so rare that — if you will forgive the bad pun — we should not ‘bank on it’.)

Naturally, if the interest rate is right an arm’s-length party will lend in these circumstances, but what is that ‘right’ interest rate and how do you prove it?

The solution

In some recent seminars, my co-director Daniel Butler and I administered the following survey:

SCENARIO 1: BORROWING TO ACQUIRE PART OF A PROPERTY

Facts

The trustee of a completely arm’s length, unrelated SMSF asks you to lend to it in the following circumstances under an LRBA:

You receive legal advice that if you exercised your mortgagee powers in respect of the tenants in common interest in the real estate, you could probably easily obtain a partitioning order by sale under which you can force the co-owner to sell at auction their half along with your half and then you split the proceeds.

Question

What would be the lowest interest rate that would entice you to agree to lend on the above terms?

RBA cash rate target (2.25% currently) +                % =                % (currently)

SCENARIO 2: BORROWING TO ACQUIRE UNITS IN A UNIT TRUST

Facts

The trustee of a completely arm’s length, unrelated SMSF asks you to lend to it in the following circumstances under an LRBA:

You receive legal advice that if you exercised your mortgagee powers in respect of the units, you could appoint whomever you wished as the trustee of the unit trust and then the assets of the unit trust would effectively be yours.

Question

What would be the lowest interest rate that would entice you to agree to lend on the above terms?

RBA cash rate target (2.25% currently) +                % =                % (currently)

The ‘longevity’ of the answers

Naturally interest rates change over time. An interest rate that is an arm’s length now might not be arm’s length in several years’ time. We of course wanted to obtain data that would still be relevant in the future.

That is why we didn’t simply ask people what the interest rate would be. Rather, we asked them what margin in addition to the RBA cash rate target they would use.

Pursuant to monetary policy, it is by moving the RBA cash rate target that the RBA seeks to move all other interest rates in the economy. Accordingly, if a related-party LRBA interest rate is expressed in relation to the RBA cash rate target (ie, RBA cash rate target plus a certain margin), as the RBA cash rate target moves, the related-party LRBA interest rate hopefully should move in what is hopefully an arm’s-length manner.

The answers

The answers were as follows:

SCENARIO ONE

The average (ie, the arithmetic mean) of the margin that should be added to the RBA cash rate target in scenario 1 is 7.24%. That is, we suspect that if a related party were lending to an SMSF in the following circumstances, non-arm’s length income would not arise.

For those who are more statistically minded, the median of the margin was 7% and the mode 6%.

SCENARIO TWO

The average of the margin that should be added to the RBA cash rate target in scenario 2 is 7.93%. That is, we suspect that if a related party were lending to an SMSF in the following circumstances, non-arm’s length income would not arise.

The median and the mode were both 8%.

The disclaimer!

I reasonably (ie, for the reasons set out above) believe that the above are the arm’s-length terms.

However, of course, there is the disclaimer. Namely, the above is all care, no responsibility. It is provided as an instructive and educational example only. It is not provided in order to be relied upon. We make no representations whatsoever that the above is a silver bullet solution to protect from non-arm’s length income, or any other issues.

Bryce Figot, director, DBA Lawyers