SMSFs warned on new non-arm’s length consequences facing unit trusts and LRBAs

In a recent DBA Lawyers webinar, director Daniel Butler said that advisers will need to be increasingly focused on the various mechanisms of the current ruling that can create traps and consequently affect SMSFs managing unit trusts and LRBAs.

In the ATO ruling, it states the requirements in ITAA 1997 paragraphs 295-550(5)(b) and (c) where the income derived by a complying superannuation fund as a beneficiary of a trust through holding a fixed entitlement to the income of the trust is NALI of the fund. 

This would apply where there is a scheme in which the parties were not dealing with each other at arm’s length, and the fund incurs a loss, outgoing or expenditure of an amount in acquiring the entitlement or in gaining or producing the income. Furthermore, the amount of the loss, outgoing or expenditure is less than the amount that the fund might have been expected to incur if those parties had been dealing with each other at arm’s length in relation to the scheme.

This means the non-arm’s length expenditure provisions apply to expenditure incurred (or that might have been expected to have been incurred) by a complying superannuation fund as a beneficiary of a trust. Examples of expenditure to which paragraphs 295-550(5)(b) and (c) may apply include a complying superannuation fund incurs non-arm’s length expenditure in acquiring the interest in the trust, or the fund enters into an LRBA on non-arm’s length terms in order to obtain funds to acquire the fixed entitlement.

Mr Butler noted it will be important for advisers to review existing unit trusts and also check if it can be considered a fixed trust when facing the applications of the ruling. 

“You need to be on top of this because paragraphs 295‐550(5)(b) and (c) are the new kids on the block,” he said.

“Para 295‐550(5)(a) has been there for a long time and while  paragraphs 295‐550(5)(b) and (c) have applied from 1 July 2018, they can still apply regardless of when the scheme was entered into.

“Paragraphs 295‐550(5)(b) and (c) can also apply to a fixed trust where NALE relates to the acquisition of the interest in that trust.

“However, para 295‐550(5)(a) can apply to income from a unit trust if the amount of the income is more than the amount that the entity might have been expected to derive if those parties had been dealing with each other at arm’s length in relation to the scheme.

“A closer focus on unit trusts is therefore needed especially if the SMSF members are performing services for the unit trust.”

Meanwhile, the ATO also discusses in the LCR the capacity in which activities are performed as a trustee that may give effect on how it can affect the non-arm’s length basis.

Mr Butler noted the ATO does recognise that trustees have statutory and fiduciary duties in addition to any duties imposed on them under the deed; they might also may have special skills and knowledge and they should generally be presumed to be acting in their trustee capacity.

Certain factors may point to an individual capacity and a trustee is generally not entitled to remuneration unless provided in the deed, and a director is not entitled to director’s fees unless approved by a general meeting of shareholders.

However, Mr Butler noted that the ruling which refers to Section 17A and 17B of SISA applies in relation to trustee remuneration for SMSFs and not trusts.

“It is interesting because Section 17A and 17B of SISA only apply to an SMSF. The ATO’s analysis in its LCRs only applied to an SMSF, so therefore we need to be careful,” he said.

“It would be nice to have clarification on this point, but there’s no clarification on this at this time. The ATO said there is an option of going for a private binding ruling for further clarification, but the position is not clear at this stage for SMSF members doing work under the unit trust and whether that would give rise to NALI.”

Impacts on LRBAs 

With the application of the new ruling, there are also several issues advisers need to be wary of when it comes to LRBAs, according to Mr Butler.

It is important to note that, previously, SMSFs with non‐arm’s length LRBAs were given until 31 January 2017 to comply with PCG 2016/5 — with effect from 1 July 2015.

The key part of the PCG is that the Commissioner accepts that 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.

With the effect of the new NALI ruling, Mr Butler said this raises the big question if the SMSF can now rely on the safe harbour in PCG 2016/5.

“The short answer is yes, and you can refer to the ATO’s response to issue number 24 in the Compendium [to LCR 2021/2] which confirms PCG 2016/5 and TD 2016/16 are still applicable,” he said.

“It is important to have that in mind as we’re now five years down the track from when the PCG was released and we’re now looking at this as a very important concession because some people may not have had all monthly principal and interest repayments.

“Also bear in mind, some deferred repayment concessions also apply to LRBAs due to COVID‐19, broadly in accordance with loan deferrals offered by the ABA [Australian Bank Association members, eg major banks] but interest still accrues and, hopefully, these will not be forgotten down the track.”

In the example provided, Kellie’s LRBA started on arm’s length terms in mid‐2018, but two years later, the loan was temporarily not on arm’s length terms for two financial years.

“The question is if that would expose the net capital gain to NALI on a future disposal, say, in 20 years’ time,” Mr Butler said.

“In applying the ATO analysis, the interest is a recurrent expense not related to the acquisition, and so, the temporary reduction in interest should not taint the capital gain.

“However, as the legislation and the ATO do not generally like related-party LRBAs, I would strongly recommend that you do not to rely upon a natural construction of the ruling in order to come to that view, and I’m highly recommending you go to the ATO to get that checked off first.”