The ATO issued ATO ID 2014/39 and ATO ID 2014/40 in December 2014. Both decisions confirm that borrowings on non-commercial terms from a related party can cause non-arm’s length income (NALI).
In October last year, the ATO confirmed it expects trustees to have these arrangements on commercial terms by 30 June this year. This means loan repayments will be expected to be in line with commercial terms for all of this financial year.
The industry has been awaiting and lobbying for guidance on what constitutes commercial terms, which the ATO has this morning released in the form of a Practical Compliance Guideline.
The full document can be accessed here.
SMSF Adviser understands that the guidance released today varies in some extent to the parameters that were put forward by an ATO-formed working group earlier this year.
The industry has now been handed two distinct group of parameters for these loan arrangements – one set for property, and one for a collection of stock exchange listed shares or units.
Essentially, these parameters are encouraging trustees to mirror the characteristics of a commercial lending arrangement, SuperConcepts national manager, SMSF technical solutions, Philip La Greca told SMSF Adviser.
As expected, the loan’s interest rate is a key determinant; however, Mr La Greca stressed that there are several other factors that need to be taken into account.
On interest rates for real property, for example, the guidance says that they may be fixed or variable, and the 2015-16 rate of 5.75 per cent may be used for LRBAs in existence upon publication of these guidelines, if the total period for which the interest rate is fixed does not exceed five years.
Loan-to-value (LVR) ratios are also critical. The guidelines prescribe 70 per cent LVR for property, and 50 per cent LVR for shares and managed funds.
Further, the guidelines prescribe a 15-year maximum loan term for property, and seven years for shares and managed funds.
“Part of the viewpoint here is that the fund wants to try and acquire the asset – so you don’t want to acquire it over too long a period, because it will obviously end up costing you more,” said Mr La Greca.
There is also no requirement for personal guarantees. Mr La Greca said there is no worth in “a member guaranteeing a loan that is effectively for them.”
The ATO is “insisting” that the security is registered, Mr La Greca also said.
“So just like when you borrow from the bank to buy a property, they put a registered mortgage on the property’s title. The lender has to do the same thing. So if you borrow, that means that the entity that you borrow the money from actually puts a registered charge on the land title of the property so that therefore it can’t be sold,” he said.
“A bank is not going to lend you money to buy a house and not put a mortgage on it,” he said.
Mr La Greca noted that there are no interest-only specifications in these guidelines.
“They’ve almost taken it back to the principal of what the law is about. We’re being allowed to borrow to acquire an asset. So the issue is, if I’m never paying off the principal, how am I going to acquire the asset in my own right?” Mr La Greca said.
However, he noted that if a trustee can conclusively prove that they are mirroring an arrangement that is commercially available with the use of an interest-only loan, that option may still be viable.
Professionals are being encouraged to act quickly to ensure their clients are compliant by the ATO’s deadline of 30 June.
“It’s going to be tight. There’s no question, it’s going to be tight,” Mr La Greca said.
For example, trustees will need to work out if they owe anything in principal and interest repayments based on the new guidelines, and if any additional principal repayments are needed to bring the LVR down, Mr La Greca said.
Mr La Greca believes these new guidelines may be the “death” of a significant chunk on non-property related-party loans.
“The more exotic stuff will probably disappear, which is probably not a bad thing,” he said.
DBA Lawyers director Daniel Butler noted these safe harbours are “critically important”.
However, he noted that professionals should ensure that the safe harbour guidelines are not being interpreted as “something they are not”.
“The safe harbours do not state that just because the terms in the Practical Compliance Guideline are satisfied NALI can never occur. Rather, they have the following more restrained comment ‘an LRBA structured in accordance with this Guideline is consistent with an arm’s length dealing and that the NALI provisions do not apply purely because of the terms of the borrowing arrangement’. For example, if an SMSF acquires an asset for a non-market value from a related party, NALI could apply,” he said.
SMSF Adviser will be publishing more detailed analysis in the Strategy bulletin this afternoon.