It is evident to many of us in the SMSF industry that the new restrictions contained in the recently released Practice Compliance Guideline (PCG) on related party LRBA loans, coupled with severe curtailment of future contributions, has dampened interest in borrowings in SMSFs.
A prudent trustee contemplating the purchase of a property using borrowings must now take greater care in establishing exactly how any loan will be repaid in a world where future non-concessional contributions will be capped at $500,000 (if not already used up previously) and concessional contribution amounts lowered significantly. Not surprisingly, many trustees and advisers are now choosing not to proceed or are at least lowering how much they’re prepared to borrow when purchasing a property in an SMSF.
One perhaps unsurprising outcome also created by this new contributions landscape has been a marked increase in using LRBAs to boost a listed share portfolio. Further supporting this, PCG 2016/5 has provided a clear path for those wishing to use related party loans in any listed security LRBA, as opposed to a loan facility from a financial institution.
Many SMSF practitioners have legitimate reservations about using LRBAs with shares. In short, they seem far more suited to property. The legal costs of creating a custodial/bare trust arrangement in addition to the borrowing costs are not insignificant. While they may represent a small portion of an LRBA with a $1 million property purchase, they would obviously eat heavily into the viability of an LRBA to purchase $50,000 of BHP shares. Even more costly is the requirement for LRBAs to be limited to a ‘single acquirable asset’ as outlined in SMSFR2012/1. The ruling states that a single collection of shares of the same class in a single company would meet this test, but a diversified portfolio would not.
Therefore, a separate LRBA is required for each company’s shares being acquired, a truly expensive exercise as the geared portfolio becomes increasingly diversified. Some large financial institutions have addressed this by creating SMSF LRBA gearing products specifically designed for shares, but this may not suit all trustees and especially those wishing to utilise related party lending. In the past, many trustees in this position have tended to drop the listed share LRBA idea as just not viable or cost effective. However, other trustees have developed a fairly simple technique to solve it, namely the creation of a ‘standard LRBA legal template’ for their fund.
Use of a standard LRBA legal template
Once developed, ideally with the assistance of a legal practitioner, this template can be effectively brought out and reused every time the trustee wishes to acquire a new parcel of shares, typically with only small modifications required. The template should ideally include the following:
- The complete bare trust/custodian legal structure. This generally stays the same across the various LRBAs.
- The terms and conditions of the loan. Again these will largely remain constant although the relevant purchase and repayment dates, interest rate, loan sum and listed share details will need to be added.
- An interest and repayment schedule outlining the monthly repayments, which must include a principal component. It’s worth noting that while each LRBA requires a monthly repayment, in practice these amounts tend to be aggregated by the fund and merged into single payment for all LRBAs each month. Heavy use of spreadsheets is advised.
Use of such a template removes a serious impediment to the use of listed share LRBAs in an SMSF, however, it’s only half the story. Apart from just having a template, great care should be employed when constructing the loan terms if the trustees wish their LRBAs to dwell in the ‘safe harbour’ of PCG2016/5.
PCG 2016/5 and the ‘safe harbour’ rules
Over the last few years, the ATO has become increasingly concerned with the growth in non-commercial loans in LRBAs. These have included loans with a low or even zero interest rate and no requirement for principal repayments. In response, the ATO issued Practice Compliance Guideline 2016/5 in April this year, overturning their previously held position. In it, the ATO outlined the characteristics required of a related party loan for the regulator to view such loans as being commercial and as such not create non-arm’s length income (NALI) issues for the fund. With respect to related party loans for listed securities, the following is required:
- An interest rate matching the RBA Indicator Rates for banks providing standard variable housing loans for investors plus an additional 2 per cent. For the 2015-16 year, this would be 7.75 per cent (2 per cent higher than property LRBAs). This must be updated every year. However, it is possible to fix the interest rate for five years.
- The term of loan can be no more than seven years and this cannot be reduced through refinancing.
- The maximum loan to value ratio cannot exceed 50 per cent (more onerous than property LRBAs that are allowed 70 per cent).
- There must be a registered charge or mortgage over the parcel of shares.
- Repayments must be done at least monthly and must include both an interest and principal component.
- All loan documentation must be done in writing and properly executed.
Benefits of a geared LRBA using related party loans
What are the benefits of using multiple related party LRBAs to create a geared share portfolio within an SMSF?
- Potentially greater returns Gearing up a share portfolio will magnify the dividends or distributions, imputation credits and capital growth although it can also obviously magnify any capital losses. Assuming the net gains over the period of the investment exceed the interest payable, such a boost will help alleviate the future lowering of allowable contributions on a member’s superannuation balances. Effectively, it can provide a ‘shot in the arm’ for super funds under the right circumstances.
- Smaller minimum balance required Shares are generally far less ‘lumpy’ than property and smaller superannuation balances can therefore be employed into an LRBA. A trustee contemplating a potential property LRBA using future contributions will probably now need to wait longer to build up the initial deposit.
- Simple and cost effective By employing the standard LRBA template and their own personal equity, a trustee can quickly establish the LRBA structure with minimal cost (essentially just their own time).
- Greater liquidity By its very nature, there is usually a ready market for listed securities and therefore the sale of all or some listed securities covered by multiple LRBAs is generally a much faster and less costly process than selling a property. This may be especially useful for those SMSFs currently in pension mode, or about to be, who may have liquidity concerns with respect to the minimum pensions. Selling part of a listed security portfolio is generally far less disruptive on a fund than being forced to sell a property.
- Diversification Trustees with properties already in their SMSFs (both directly or through an LRBA) might wish to grow a share portfolio to provide greater diversification rather than using surplus funds to hold another ‘lumpy’ asset.
While not suitable for all trustees, multiple LRBAs using related party loans can be a powerful strategy for SMSFs seeking greater performance from their SMSF without the greater complexities of a traditional bank-funded LRBA.
Christopher Levy, partner, Aquila Super