Related-party loans, huge tax bill?
A look at a recent private binding ruling may come as a shock to practitioners who are advising on borrowing in an SMSF.
The ATO has released a private binding ruling suggesting that an overly favourable related-party SMSF loan can give rise to significant negative tax implications.
This might come as a shock to many who incorrectly thought that the ATO previously gave a ‘carte blanche’ to such arrangements.
Facts of the private binding ruling
At the risk of oversimplifying, the related-party loan was to have the following characteristics:
• nil interest
• unspecified maximum duration of the loan (but the intention seemed to be to allow a term of up to several decades)
• no personal guarantees required
• the borrower was obliged to repay the loan as a single lump sum at the end of the loan term, or earlier as agreed between the borrower and lender
• the loan was to acquire listed ASX shares (there was to be another loan to acquire units in what appeared to be a private unit trust).
The above facts strongly suggest that the terms of the loan are not those expected in arm’s length dealings.
The ATO was asked a number of questions, including whether the income derived would be non-arm’s length income.
They said that it would be, and accordingly the income would be taxed at 45 per cent! This high rate of tax would apply regardless of whether the SMSF was in pension mode … that is, the non-arm’s length income provisions override the pension exemption.
The ATO’s reasoning was as follows:
If the parties in this case were dealing with each other at arm's length, the amount of income the Fund might be expected to derive through the Custody Trust is either:
* nil - on the basis that no lending on the proposed terms by the [related-party lender] might be expected and therefore no income might be expected to be derived by the Fund through the Custody Trust; or
* is less than under the proposed arrangement - on the basis that the Family Trust might be expected to lend on commercial terms that involve lower than 100 per cent loan-to-value ratios given the nature of the assets to be acquired with the borrowed money and the limited recourse nature of the loans. Therefore, the substantially lower borrowed amounts available to be invested might be expected to generate less income to be derived by the Fund through the Custody Trust than under the proposed arrangement.
Either way, the final requirement of subsection 295-550(5) of the ITAA 1997 is satisfied.
Would the outcome be different if the facts were less aggressive?
At the time of writing, there are no publicly available 2014 private binding rulings considering nil interest loans with less aggressive facts (eg, a less than 100 per cent loan-to-value ratio).
However, extreme caution should still be used. It is vital to be able to prove that the amount of income derived would be no greater than if the parties were dealing on arm’s length terms.
But didn’t the ATO previously say it was okay?
The ATO has released private binding rulings in the past stating to the specific taxpayer applicants that their income would not be non-arm’s length income (see, for example, private binding rulings 1012414213139 and 1012396819768). Naturally though, private binding rulings are not public rulings and can only be relied upon by the specific taxpayers who applied for them.
The ATO has made public comments regarding contributions, as well as the arm’s length provisions in the Superannuation Industry (Supervision) Act 1993.
Originally, there was a concern that a related-party loan favouring an SMSF would constitute a contribution and therefore give rise to excess contribution tax issues.
The ATO in taxpayer alert TA 2008/5 stated it was concerned about such loans. It said monies advanced by a member or related party at zero or less than a commercial rate of interest could be characterised as a contribution to the SMSF. This may result in the trustee/member having to pay excess non-concessional contributions tax under Division 292 of the Income Tax Assessment Act 1997...
Although taxpayer alert TA 2008/5 has never been formally withdrawn, the ATO has moved away from this position. See item 7.4 in the June 2012 Superannuation Technical minutes of the National Tax Liaison Group. Here, the ATO said that saving an interest expense (as a result of a favourable interest rate) is not necessarily a contribution and that a nil interest rate will not prevent the arrangement from being a borrowing.
Provided the loan favours the SMSF and does not favour the related party, the ATO seem to take the view that the arm’s length requirements in the SIS legislation are not contravened. See ATO ID 2010/162.
Bryce Figot and Daniel Butler are directors at DBA Lawyers.