Speaking in a recent Knowledge Shop webinar, Hayes Knight director of SMSF Ray Itaoui said that, when accountants are preparing the accounts for an SMSF with a related party or non-bank loan, they may not consider the safe harbour provisions and submit the fund to the audit thinking everything is okay.
Mr Itaoui explained that, back in 2016, the ATO released PCG 2016/5, which provided the terms for how an SMSF can structure a loan at arm’s length with a non-bank SMSF or privately funded loan.
The safe harbour terms, he noted, included requirements such as an interest rate which is equal to the RBA indicator rates, which for the 2018 financial year was 5.8 per cent; monthly and principal repayments; maximum 15-year term with a maximum of five years of fixed interest; an LVR of less than 70 per cent; and a registered mortgage.
“The ATO has said if you meet all of these requirements then we deem the loan to be at arm’s length,” he noted.
“Previously, there were a lot of loans provided at zero per cent interest, and it became difficult to understand with these private loans how to determine what an arm’s length loan would be, and these are the instructions that the ATO gave us, to say that if you meet these requirements, these safe harbour terms, your loan will be consistent with arm’s length and you won’t have any issues.”
Mr Itaoui said that, sometimes, accountants can put together the accounts for funds with these loans thinking that everything was prepared currently, and that because a lawyer was involved it should all be okay, but there can end up being misstatements in the financials.
If there was a loan that largely met the safe harbour provisions, for example, but there was no monthly principal and interest repayments, just interest-only repayments, then based on that, the auditor could argue that the safe harbour provisions had actually not been met.
“If the safe harbour provisions aren’t met, then what happens is non-arm’s length income will apply, which may create tension between the accountant and auditor,” he said.
“The financials have been misstated materially depending on how large the loan is, and if non-arm’s length income applies to all the income that is derived from that property and it’s not reflected in the accounts, the auditor can go in and qualify part A of the audit report.”
However, Mr Itaoui warned that, before going straight to qualifying part A of the audit report, the best course of action is for the auditor to first discuss it with the accountant.
“What I’m tending to see is that auditors are tending to qualify part A of the audit report without discussing this with the accountants, whereas the best solution would be to talk to the accountant and try and come up with a plan to rectify the issue,” he explained.
“It could be that non-arm’s length income is being picked up in the account and steps are being taken to rectify that issue moving forward so you don’t have a repeat of that breach.”
Mr Itaoui said that it is an issue he comes across quite regularly.
“An example I came across on my desk the other week was where the accountants tried with their clients to get this completed correctly with the intention of getting everything right, but the solicitor made an error and didn’t include principal and interest repayments on the loan agreement and that’s why the loan didn’t meet the requirements,” he explained.
“I’ve also seen a lot of funds try to meet this requirement but not include a registered mortgage on the title as well.”
Elijah you are correct with regards to non-arm’s length income not automatically applying if the safe-harbour provisions are not met. The comment was following on from a scenario where there were interest-only repayments being made. We are yet to see a trustee able to prove that this type of arrangement is on commercial terms, i.e. that they could have obtained a loan with the same terms from an external lender. Paperwork is key, and if a trustee can prove this, then non-arm’s length income is not applicable.
I disagree with the following conclusion reached in this article – “If the safe harbour provisions aren’t met, then what happens is non-arm’s length income will apply, which may create tension between the accountant and auditor,”
Perhaps I am missing something but, PCG2016/5 clearly states that not meeting the safe harbor provisions does not automatically mean it is not at arms length if the trustees can otherwise demonstrate the loan is of a commercial nature.
“4. If SMSF trustees have entered into an arrangement which does not meet all of the ‘Safe Harbour’ terms set out in this Guideline, whilst the trustees are unable to be assured that the Commissioner will accept the arrangement to be consistent with an arm’s length dealing, [b]it does not mean that the arrangement is deemed not to be on arm’s length terms.[/b] It merely means that there is no certainty provided under this Guideline. The trustees will need to be able to otherwise demonstrate that the arrangement was entered into and maintained on terms consistent with an arm’s length dealing. One example of how a trustee may demonstrate this is by maintaining evidence that shows their particular arrangement is established and maintained on terms that replicate the terms of a commercial loan that is available in the same circumstances.
Safe harbour provisions are ONLY for non-arms length lenders….a [b]non-bank lender is still a commercial lender[/b]. A loan that does not meet safe harbour does not automatically mean that non-arm’s length income will apply – the point is whether the loan is on commercial terms.