One of the major issues with LRBAs has been around the terms of loans from related parties.
In December 2014, the ATO confirmed that in its view, all loans by related parties to trustees of SMSFs must be on terms that are consistent with an arm’s length dealing (see ATO IDs 2014/39 and 2014/40). If the loan terms were not, then the income from the LRBA is non-arm’s length income to the SMSF and taxed at the top marginal tax rate in the SMSF (instead of the normal rate of 15 per cent, or no tax for income from assets supporting an income stream or pension).
This meant that the trustees of SMSFs who had borrowed from a related party must review the terms of their loan arrangements to ensure they on the same terms as what an arm’s length lender would require.
The ATO provided an effective deadline of 30 June 2016 for trustees of SMSFs to get their loan arrangements in order.
To provide certainty around what the ATO considers arm’s length terms, in April 2016 the ATO released PCG 2016/5. It contains safe harbour terms that the ATO will accept are arm’s length, so if followed, the income from the LRBA will not be considered non-arm’s length income to the SMSF purely because of the terms of the borrowing.
What are the safe harbour rules?
This is a summary of the key safe harbour rules:
When must the LRBA comply by?
The safe harbour rules apply both to existing LRBAs and those established after the release of PCG 2016/5.
In PCG 2016/5, the ATO confirms it will not select an SMSF for an income tax review for the 2014-15 or earlier years purely because the SMSF has entered into an LRBA if by 30 June 2016:
• all loans are on terms consistent with an arm’s length dealing, or the LRBA is wound up; and
• the SMSF trustee has made principal and interest payments for the 2015-16 year that are consistent with an arm’s length dealing.
Are there other options?
The ATO accepts that alternative loan terms can be consistent with an arm’s length dealing, but the onus will be on the trustees of the SMSF to establish they are consistent with an arm’s length dealing.
This means the options for trustees of SMSFs with LRBAs that have loans from related parties are to:
1. ensure the terms of the related party loan comply with the safe harbour rules by 30 June 2016 (including making principal and interest payments for the 2015-16 year consistent with an arm’s length dealing);
2. wind up the LRBA by 30 June 2016 (for example, by selling the asset or paying out the debt and transferring it to the SMSF), having made principal and interest payments for the 2015-16 year consistent with an arm’s length dealing; or
3. ensure they have extrinsic evidence that the terms of the existing arrangement are consistent with an arm’s length dealing (for example, because they are substantially the same as an offer of finance from a bank).
Is it just the loan terms to worry about?
The terms of the loan are an important part of an LRBA, but there are many other rules that are just as important. A breach of any of the rules can result in compliance issues for the SMSF or for the income from the LRBA to be non-arm’s length income to the SMSF (and taxed at the top marginal tax rate).
Now is a good opportunity for trustees of SMSFs to review their LRBAs, particularly where the lender is a related party, not only for the loan terms, but also for compliance with all the other rules as well.
Scott Hay-Bartlem, partner, Cooper Grace Ward