ATO provides ‘welcome’ guidance on NALI for LRBAs

The ATO released Practical Compliance Guideline (PCG) 2016/5, back in 2016, which sets out the safe harbour terms on which SMSF trustees may structure their LRBAs consistent with an arm’s length dealing.

PCG 2016/5 gave SMSF trustees the opportunity to review the terms of their fund’s limited recourse borrowing arrangement (LRBA) before 31 January 2017.

The guideline outlined that the terms of the LRBA would not be subject to any further compliance action for the 2014-15 income years or before if by 31 January 2017 the LRBA had been restructured on terms consistent with an arm’s length dealing or the LRBA had been brought to an end and the principal and interest made were made under LRBA terms consistent with an arm’s length dealing.

PCG 2016/5 stated that SMSF trustees who satisfied these conditions, and applied the guideline in good faith to revise the terms of their existing LRBAs before 31 January 2017, could be assured that the terms of their LRBA would not be subject to any further compliance action by the ATO for the 2014-15 years and prior.

Following the amendments to section 295-550 of the Income Tax Assessment Act 1997 relating to NALI and non-arm’s length expenses (NALE), however, the ATO then released LCR 2021/2.

LCR 2021/2 outlined that an LRBA that is not consistent with arm’s length terms such as a zero-interest loan would be a non-arm’s length expense of a recurrent nature that related to the acquisition of an asset, explained Colonial First State head of technical services Craig Day.

“Therefore any future income or capital gains realised from that asset would be non-arm’s length income because it was acquired under a non-arm’s length arrangement involving a NALI expense,” said Mr Day.

“What they also said in that LCR 2021/2 was that if that is the case, you can’t ever fix that arrangement. So even if you refinance that arrangement to be at market rate, then the income that you’re going to derive from that asset will always be non-arm’s length income because you originally set it up as a non-arm’s length arrangement.”

Mr Day said this contradicted PCG 2016/5, which stated that SMSF trustees would be fine as long as the LRBA had been restructured before 31 January 2017.

The ATO has now updated PCG 2016/5 to reflect an extension of the Commissioner’s compliance approach to the application of the NALI provisions to LRBAs entered into prior to the 2014-15 income year and that were made consistent with an arm’s length dealing by 31 January 2017.

The ATO has inserted paragraph 17A into the guideline, which states that an SMSF trustee who satisfies the condition set out in paragraph 16(i) of the guideline with respect to an LRBA “can also be assured that the Commissioner will not apply compliance resources to determine whether paragraphs 295-550(1)(b) or (c), or paragraphs 295-550(5)(b) or (c), of the ITAA 1997 apply to income derived by the SMSF for the 2018-19 and later income years from an asset that is subject to that LRBA”.

“With this new insertion, they’re basically saying well as long as you complied with those requirements by 31 January 2017 by putting that non-arm’s length LRBA into an arm’s length arrangement, then we won’t be applying any compliance resources towards determining whether that income is going to be non-arm’s length income in the future,” Mr Day explained.

Mr Day said this is welcome news for advisers and means there is now a more consistent approach, regardless of the fact that the rules changed after the publication of the original safe harbour ruling.

DBA Lawyers director Daniel Butler said the new insertion to PCG 2016/5 provides greater clarity for advisers dealing with clients with these types of LRBAs.

“There were numerous SMSFs with non-arm’s length LRBAs in place prior to February 2017, which were hopefully made compliant with PCG 2016/5 by 31 January 2017,” he said.

He noted that the joint professional bodies had sought guidance on this issue following concerns that an asset that was originally subject to a non-arm’s length LRBA could be subject to NALE from 1 July 2018, despite the fact it had been restructured to satisfy PCG 2016/5.

“The ATO previously orally confirmed that they generally would not apply compliance resources to SMSFs that rectified as of 31 Jan 2017 but that provides no protection to funds that are subject to an ATO review or audit in the normal course of ATO activities,” he said.

While the updated guideline has provided clarity on this particular NALI issue, Mr Butler said a change of law is still required to ensure NALI is applied in a fair and proportionate manner.

“There is still considerable uncertainty relating to NALI and NALE given the ATO’s broad view reflected in LCR 2021/2 which is still causing lots of issues in practice,” he said.