Background

Through the course of the 2015/16 financial year, trustees of SMSFs were put on notice that their related party LRBAs needed to be on a commercial basis by 30 June 2016. The ATO subsequently deferred that 'Key Date' to 31 January 2017.

Additionally, the ATO released guidance in the form of:

- Practical Compliance Guidelines PCG 2016/5; and

- Taxation Determination TD 2016/16.

If we consider that, in the ATO's view, income generated by SMSF investments using non-commercial related party loans gives rise to non-arm's length income (NALI), which is taxed at the top marginal rate, we can see why the deadline of 31 January 2017 is very important for many SMSF trustees.

The ATO guidance provides the following options to SMSF trustees with related party LRBAs:

• Determine if the arrangement meets the safe harbour guidelines;
• If not, whether they can meet those guidelines;
• If they can meet the guidelines, whether they wish to meet the guidelines; and
• If the safe harbour guidelines will not apply, if they wish to amend the terms of the loan to be in line with a commercial hypothetical loan arrangement.

Safe Harbour

PCG 2016/5 provides a 'safe harbour' option for trustees, in that there is a high degree of certainty that NALI will not apply if the terms of the loan arrangement fit within the safe harbour provisions in PCG 2016/5 as detailed in the table below.

TD 2016/16 contains a scenario whereby an SMSF entered into a related party loan to purchase an asset which was providing rental income of $1,000 per week. The table below sets out the details of the arrangement (‘Current LRBA’ column) and also provides details of an acceptable hypothetical borrowing arrangement which, incidentally, matches the safe harbour provisions under PCG 2016/5.

Hypothetical Loan

A shortfall of PCG 2016/5 is that it only provides for investments in real estate and listed shares or units, and does not provide for a range of other potential SMSF investments, including managed investments and unlisted shares or units.  As such, if a client is unable to amend their arrangement to fit within the safe harbour guidelines, or chooses not to, or has invested in an asset not covered by PCG 2016/5, they may choose to seek a workable alternative under TD 2016/16 and rely on a hypothetical loan scenario to demonstrate arm’s length terms instead.

Examples provided in TD 2016/16 look at the terms of the arrangement and compare those terms to a hypothetical borrowing arrangement which the trustee may obtain in the marketplace. The hypothetical arrangement must be justifiable on a commercial basis.

According to TD 2016/16, that hypothetical arrangement would need to consider the applicable interest rate, and whether the rate is fixed or variable, the term of the loan and the loan to value ratio. If, under the hypothetical borrowing arrangement, it would be possible for the trustee to borrow from an unrelated lender, the income from the investment would not be NALI.

In TD 2016/16, the ATO reviews a number of components for consideration under the hypothetical borrowing arrangement, including:

• Terms of the trust deed;
• Available capital (LVR);
• Cash flow;
• Whether the investment:
• Represents optimal use of fund assets; and
• Is earnings accretive; and
• Any legislative or regulatory impediments.

TD 2016/16 contains a scenario whereby an SMSF entered into a related party loan to purchase an asset providing rental income of $1,000 per week. The table below sets out the details of the arrangement (‘Current LRBA’ column) and also provides details of an acceptable hypothetical borrowing arrangement which, incidentally, matches the safe harbour provisions under PCG 2016/5.

From the table above, you will note, to avoid a NALI determination:

• The LVR is 70 per cent - the SMSF will need to source $300,000 to pay down the loan;
• The interest rate needs to increase;
• The term of the loan needs to be reduced; and
• The payment frequency needs to change.

Unfortunately, the fact that the ATO used the safe harbour provisions for their example means that there is still a lack of clarity for those that do not specifically meet the safe harbour terms, and wish to use the hypothetical loan option - (e.g. longer loan term or higher LVR).

In addition, the fact that the rental of $1,000 per week is less than the monthly principal and interest requirement of $5,800 appears to lead the ATO to the conclusion that the SMSF would not have been able to borrow under those hypothetical terms and, as a result, the income from the investment will be NALI. If that is the case, the $1,000 per week rental would be taxed at the top marginal rate.

However, the ATO did make reference to cash flow considerations. Arm’s length lenders also consider income expected to be received by the fund, such as:

• Investment income; and/or
• Future contributions.

Where to from here?

Whilst PCG 2016/5 provides a large degree of certainty that NALI will be avoided, it only applies to real estate and listed shares or trusts.

Trustees also have the option to construct a hypothetical loan arrangement, based on realistic factors, in accordance with TD 2016/16, and have the arrangement meet those hypothetical terms.

That hypothetical arrangement can apply to a broader range of investments, such as managed investments and related trusts.

The alternative to the above is to have the income from the investment (including realised gains) treated as NALI.

It is not too late to change

With the 31 January 2017 deadline fast approaching, examining related party LRBAs sooner rather than later is essential.  Key aspects to assess, based on PCG 2016/5 and TD 2016/16, include:

• The interest rate, including the percentage, whether fixed or variable terms and whether payments from 1 July 2015 match that rate;
• The term of the loan;
• The LVR;
• The security provided to the lender;
• Compliance with the loan agreement, including principal payments; and
• Whether effective documentation is in place in respect of the loan, including any varied arrangements, to meet the safe harbour or hypothetical terms.

Following the examination, trustees have a number of options available to them to bring the transaction into line, including:

• Paying down the loan to bring the LVR to the accepted level;
• Amending the terms of the loan agreement in relation to the term of the loan, interest rate, principal repayments and security in place. In doing so, however, care should be taken to ensure that current shortfalls in interest and principal payments can be topped up prior to 31 January to bring the transaction into line by that date;
• The adoption of security documentation such as mortgages.

Michael Harkin, national manager for training and advice, Topdocs