There has long been discussion about the terms of related party loans to SMSFs, and particularly whether interest must be paid on those loans, and if so at what rate.
In 2014, the ATO made its position clear – if the arrangements are not on commercial terms (for example the interest rate charged is not a market interest rate), there can be serious tax and compliance consequences for the SMSF (see ATO IDs 2014/39 and 2014/40). This was quite different to the position the ATO had taken in previous private binding rulings, but clearly sets out their current view.
At a speech on 20 October 2015, the ATO announced it would allow a grace period for SMSFs to rectify existing interest-free, low rate or uncommercial loans from related parties before 30 June 2016. In particular, they said:
‘…the commissioner will not allocate resources to undertaking any compliance activities or actions in relation to those arrangements provided commercial terms are in place by 30 June 2016. This time frame is intended to allow funds sufficient time to further consider their particular circumstances and arrangements and, if necessary, to restructure arrangements on commercial terms without detriment.’
So, this means all SMSFs must review their related party loans and ensure they reflect ‘commercial terms’. But what are ‘commercial terms’?
Much of the discussion has centred on the interest rate, and this is clearly a key factor in the commerciality of the terms. It is very important to be able to prove the interest rate is what an arm’s length lender would have charged – a letter (preferably a finance approval letter) from a bank or other financial institution is the best way of establishing this.
But a finance approval letter contains more than just the interest rate. In various private binding rulings, the ATO has focused on other factors beyond just the interest rate, and the ATO’s view applies to the arrangement as a whole. This includes ensuring proper documentation is in place, an LVR that mirrors what a bank would require, the security taken (and actually registered), guarantees given and the repayment terms. How often does a bank or other financial institution lend to a SMSF without a signed loan agreement, mortgage and guarantees from the members? Then your related party loan to your SMSF must also have those things.
And once all your documentation is in place, your SMSF must comply with the terms – if monthly payments are required, they must be made and they must be the correct amount.
Many SMSFs obtained private binding rulings on these arrangements. If you want to rely on your private binding ruling, make sure the arrangements as implemented are identical to that on which the private binding ruling is based, and check the years to which it applies. The ATO rarely gives private binding rulings for indefinite terms. Your private binding ruling will be of little protection if it does not reflect what actually occurred or the years to which it applies have come and gone.
Scott Hay-Bartlem, partner, Cooper Grace Ward