The SMSF audit post-COVID-19 — related-party LRBAs
The SMSF industry is experiencing rapid change in the wake of COVID-19. The goal posts of commerciality have shifted, together with the rules surrounding SMSF related-party limited recourse borrowing arrangements (LRBAs).
What are the audit implications for related-party LRBAs in this new landscape?
Like related tenancies, an arm’s-length standard of dealing is essential to avoid compliance breaches and the incurrence of non-arm’s length income (NALI).
The ATO refers to the Australian Banking Association’s website for the commercial standard of dealing with real estate investment loans in a post-COVID-19 environment. Industry relief for these loans permits a deferral of principal repayments up to six months. Interest will accrue on the loan over this period and must be caught up at a later point. As per its FAQ page, this is the ATO’s approved commercial benchmark for SMSF related-party borrowing.
A related-party lender may therefore offer the same to their SMSF without jeopardising the principle of arm’s-length dealing (SIS section 109) and without giving rise to NALI.
Let’s unpack this in further detail.
Can a related party lender vary the interest rate or extend the loan term due to COVID-19?
No, not without jeopardising section 109 and the NALI provisions.
Changes in the interest rate or loan term are not currently being extended for real estate investment loans in the banking industry (though the term may be negotiated on a case-by-case basis). Concessions in rate and term are therefore not included in the ATO’s guidance for SMSFs. All principal repayments and interest may be deferred for six months due to COVID-19’s financial impact. The need for further relief must be reviewed at the end of this deferral period.
Does this mean the SMSF will have to make a large catch-up interest payment?
Possibly. It depends on commercial practice going forward.
Interest payments will be capitalised over the deferral period. Both accrued interest and deferred principal repayments must be subsequently caught up and remain in line with arrangements offered by commercial banks at the time. Until further guidance is received, SMSF trustees may assume that deferred repayment of accrued interest and principal will be caught up over the remaining life of the loan.
Will a decline in leveraged investment value affect the borrowing’s commerciality?
The Australian Banking Association has confirmed that commercial banks will not enforce business loans for non-financial breach of contract, as may occur through a fall in property values.
An increase in the loan-to-value ratio (LVR) due to a decline in property prices is therefore an anticipated contingency and will not affect the commerciality of related-party lending within an SMSF. The LVR for borrowings secured by listed or unlisted securities is also likely to increase due to the financial impact of COVID-19. The commerciality of these borrowing arrangements is similarly unaffected.
It is important to note that the ATO’s safe harbour guidelines for non-bank LRBAs (which stipulate a maximum LVR of 70 per cent for commercial and residential property and 50 per cent for listed shares) assess the LVR only when the loan commences or is re-financed. The LVR is not annually re-assessed in the context of the safe harbour guidelines.
As always, it is advisable to review existing loan documentation. If the loan agreement includes financial or non-financial covenants impacted by COVID-19, legal assistance should be sought to ensure appropriate action is taken.
Preparing the SMSF for audit
The SMSF auditor must form an opinion as to the commerciality of related-party borrowing arrangements.
They will need sufficient appropriate audit evidence from SMSF trustees to support this opinion.
This evidence should include:
Minute/resolution: A minute or resolution should confirm the change in loan agreement terms. The document must include the reason for this change. It should refer to current banking practice in support of the measures implemented and set a time frame for the review of these measures (i.e. six months).
Loan repayment schedule: An updated loan repayment schedule should be provided, showing a temporary freeze on principal repayments and the accrual of loan interest over the deferral period. The SMSF’s loan repayment schedule should reflect commercial banking practice. The Australian Banking Association has indicated that deferred repayments of interest and principal will be caught up over the loan’s remaining life.
If the auditor finds that a related-party LRBA has not been commercially maintained, they must:
- Recognise a contravention of SIS Act section 109 and the incurrence of non-arm’s length income by the SMSF and communicate these matters to the trustees in the management letter.
- If the contravention of section 109 is material, modify the Part B Compliance Audit Opinion. If the contravention is reportable under the regulator’s reporting criteria, report the section 109 contravention (and any other contraventions) as usual to the ATO.
- If the financial statements do not recognise the correct tax provision resulting from NALI and the misstatement is material, modify the Part A Financial Statement Audit Opinion.
Temporary repayment relief is available for related-party LRBAs where the borrower (the SMSF) has been financially impacted by COVID-19. The commercial banking standard permits a suspension of all principal and interest repayments for six-month period. The interest will accrue over this time and must be caught up at a later date.
For those SMSFs swimming between the flags, the annual audit should prove no obstacle.
In terms of audit evidence, just ensure that the change in loan terms is documented, that the rationale for adjustment is explained and that the accrual of interest is borne out by a revised loan repayment schedule.
Naomi Kewley, managing director, Peak Super Audits