Meeting the ATO's new related-party loans deadline
SMSFs with non-commercial related-party loans are now aware of the deadline for fixing these arrangements, but the question is: will this be long enough?
Last week the ATO set 30 June 2016 as the deadline for fixing related party limited recourse loans and having them on commercial terms. The ATO announced that the commissioner would not allocate resources to undertaking any compliance activities or actions in relation to those arrangements, provided commercial terms are in place by 30 June 2016.
For related-party loans, the focus has been on the interest rate – for example, where the interest rate is below market or even zero. However, it is the whole loan arrangement that will have to be on commercial terms to avoid further investigation by the ATO. This includes the term of the loan, the loan to value ratio and the repayment terms.
Effectively, the SMSF would, in my view, have to show that it could obtain a loan from an arm’s-length lender on terms the same as those for the related-party loan. Where this involves a reduction of the LVR, for example, and consequently requires a repayment of loan principal, how will the SMSF make this repayment by the deadline?
Let’s take the example in ATO 2014/40:
The SMSF borrowed from a related party under an LRBA as follows:
Property acquired under the LRBA was a commercial property;
The lender was the members of the SMSF in their personal capacity;
The key features of the related-party, limited-recourse loan were as follows:
The amount borrowed was approximately $500,000.
The loan term was 15 years.
The fund trustee must make periodic monthly repayments of the loan principal. The periodic repayments will ensure that the loan principal is fully repaid by the end of the loan term.
The interest rate is 0 per cent.
The amount borrowed under the loan was 80 per cent (LVR) of the purchase price of the asset. Thus, given a loan of $500,000, the purchase price would have been $625,000.
A mortgage in favour of the lenders has been registered in respect of the asset.
No personal guarantees or other security were given to the lenders in relation to repayment of the loan.
Apart from the interest rate being below market, the other concern that the ATO had with the related-party arrangement was that the LVR of 80 per cent was not commercial, as evidence provided by the taxpayer was that the LVR from a commercial lender would be between 60 per cent and 70 per cent. It was noted that a higher LVR could be achieved where additional security from sources external to the fund are provided. However, the terms of the related-party loan did not require or provide for such additional security.
So how could this arrangement comply with the 30 June 2016 deadline?
Firstly, the interest rate would need to be lifted so that it reflects a commercial rate for this type of loan. The loan agreement would require provisions to enable the change to the interest rate.
Secondly, as the terms of the loan do not provide for additional external security, the loan amount would need to be reduced such that the LVR fell within the 60 per cent to 70 per cent range, as per the evidence provided. This would require the SMSF to make a loan principal repayment of at least $62,500, assuming the market value of the property remains at $625,000, to reduce the LVR to the upper evidentiary threshold of 70 per cent.
Will the SMSF have the funds to make the loan repayment by the 30 June 2016 deadline? What if the loan was on an LVR of 100 per cent (as in ATO ID 2014/39)? The loan repayment required would be $187,500, making it harder for the SMSF to find the cash to make the loan repayment. Of course, one option would be for the members of the fund to make non-concessional contributions of the required amount, subject to contribution caps. The SMSF would then repay the members, in their capacity as the lender to the fund, resulting in a nil cash flow position for the members. However, where the members cannot fund the required non-concessional contribution then a temporary finance arrangement may be required – something that cannot be left until the last few days prior to the deadline.
Alternatively, where the related-party lender is a member of the SMSF, a forgiveness of part of the loan (equal to the required principal reduction amount) can achieve the same result. TR 2010/1, paragraph 36 notes that a contribution includes an increase of the fund’s capital “when a liability incurred by the superannuation provider is forgiven by the person to whom the liability is owed”.
The above scenario, to me, is a fairly straight forward one to fix by the deadline. However, I expect that there are many scenarios where compliance by the deadline will be more difficult, if not impossible. Take for example the following scenarios:
The SMSF borrowed under an LRBA from a commercial lender; however, there was a shortfall in funds to make the acquisition. The shortfall was achieved via a second limited recourse loan from a related party. Which commercial lender will lend to an SMSF and rank second on the mortgage? This will most likely require the second loan to be repaid by 30 June 2016.
The asset acquired under the LRBA is one that no commercial lender will lend on. Remember the days when no bank would lend to buy a child care centre or squash court centre?
The related-party lender has loaned money for the SMSF to acquire under an LRBA a 50 per cent interest in a property held as tenants in common with a related party. As we know, it is very difficult if not impossible to get a commercial lender to take a less than 100 per cent security over an asset.
SMSF clients that are affected by this deadline need to be identified and contacted as soon as possible to commence these discussions and implement a plan to resolve the issue before the ATO does allocate resources for compliance review activities.
Mark Ellem, policy director, Supercorp