Speaking to SMSF Adviser, AMP SMSF’s head of policy and technical Peter Burgess explained the private ruling relates to an SMSF borrowing 100 per cent of an asset’s value on an interest free, related-party loan.
In this private ruling, Mr Burgess said the “good news” is the ATO does not consider the difference between interest calculated using an arm’s length interest rate and a nil interest rate to be a contribution made to the fund.
“The bad news is in the circumstances set out in the ruling, they believe the parties were not dealing at arm’s length, and as a result the fund would receive more income than would’ve been the case if they were dealing at arm’s length,” Mr Burgess said.
“That income is considered to be non-arm’s length income, which means the fund has to pay tax on it at the rate of 45 per cent,” he added.
The conclusion was the 100 per cent loan to value ratio was not on commercial terms and therefore a substantially lower borrowed amount which would have occurred if it was on commercial terms might be expected to generate less income for the fund, Mr Burgess said.
“Essentially what they’re saying here is that if you have a limited recourse borrowing arrangement with a related party loan and the trustees are borrowing 100 per cent of the purchase price of the asset, it’s unlikely to be a commercial arrangement,” Mr Burgess said.
“Therefore the trustees are obliged to treat the income that the fund receives as non-arm’s length income, particularly if there is no interest being charged or other loan terms when assessed holistically are not on commercial terms.
“This is a ‘landmark’ decision… the ATO has previously said zero interest rate loans are not necessarily going to breach the rules, but this decision says it may result in the income being treated as non-arm’s length income, which may compromise the tax efficiency of the whole strategy.”
Mr Burgess said the ATO took a holistic view of the facts to come to this decision – that is, it examined all the factors associated with the loan when considering whether the parties were dealing at non-arm’s length.
“To avoid situations like this, if you are going to have a related party loan as part of your LRBA, then ensure that the terms are on an arm’s length basis, which means that you do charge interest, that there are loan repayments being made, and the LVR is on a commercial basis,” Mr Burgess said.
“My experience has been that practitioners and trustees are typically very cautious about these things and have in the past looked to put in place a repayment schedule and charged interest on the loan,” he added.
“They’ve tried to make it commercial and I think that’s prudent, and perhaps even more prudent as a result of this private ruling because that’s what the ATO has said in this ruling… if you want the income to be taxed at concessional rates, then [the ATO expects] to see these arrangements set up on a commercial basis.”
The ATO warns that private binding rulings should not be used to predict ATO policy or decisions. However, Mr Burgess said this ruling provides useful insight into the way the ATO would apply the tax laws in situations where an SMSF trustee borrows from a related party under a limited recourse borrowing arrangement.
Super
This outcome just highlights what I have warned for a long time. The Tax Office will issue a publication covering one issue and not fully consider the potential array of consequences. Super Law is complex and the intersection with tax law will continue to trip people up.
My prediction is that the next “landmark decision” will be a recoil from contributions reserving by SMSF’.
I agree John. Back in the pre GFC it was common to see greater than 100% from the banks on residential property. WHO is the ATO to tell the banks or me what is commercial? If they have to stick their nose in, then why did they encourage LRBA a few years?
Why do you think this particular private ruling is a landmark when there are already at least two other private rulings that say it is perfectly fine to charge a zero interest rate, namely PBR 1012396819768 and PBR 1012414213139 which particularly states:
In this case, the Fund will derive a greater level of taxable income because the rate of interest payable by the fund is reduced to 0%. That is, the level of taxable income derived by the Fund will be inflated as a result of a lower level of deduction amounts than would normally be incurred if the parties were dealing at arm’s length. However, subsection 295-550(1) of the ITAA 1997 does not apply in these circumstances as this subsection applies strictly to amounts of ordinary or statutory income, not taxable income.
Sorry,but I need to speak up as you are contradicting advice I have given.
If I did not inform clients of this advantage I would be negligent.
I’m not sure how they work out whether the loan to value ratio is on commercial terms. 100% finance is available in a number of commercial transactions especially in geared equity trusts where you can borrow the full 100% and the security is the shares themselves with limited recourse to the borrower. Seems the ATO are trying to be bankers and not tax experts.
How can you say that a private ruling is more correct than ID 2010/162 where,the ATO say you can use below market rates?
In the private ruling the ATO gets confused as to just what a custodial trust is. The response talks about the SMSF receiving net income from the custodial trust. Certainly if that was the case then the income of the SMSF would be higher because of the interest free loan but this is not the case. The custodial trust is a bare trust, the income that is earned by the assets it holds is the direct income of the SMSF and the borrowings are a direct liability of the SMSF. So both the interest and income would be shown separately in the SMSF accounts and as a result the income from the investment would be exactly the same whether interest was paid or not because the interest is merely and expense not income.
If read the full section 295-550 you will see that it is all about avoiding the streaming of artificially high income into a SMSF
Interesting reading
A very informative article on making sure loans to SMSF are at arms length. Article is on a Private Ruling where a SMSF had been loans money from a related entity on a non commercial bases