The ATO has issued a private binding ruling which provides insight on the potential tax implications that can occur with limited recourse borrowing arrangements in an SMSF.
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.
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