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SMSFs, LRBAs and NALI

Daniel Butler, DBA Lawyers
17 February 2021 — 9 minute read

When dealing with limited recourse borrowing arrangements (LRBAs), it is important to understand the consequences that may arise where the LRBA is not implemented and maintained on a proper basis.

This is especially so in the case of a self-managed superannuation fund (SMSF) undertaking a related-party LRBA. The terms and conditions of such an LRBA should either comply with the ATO’s safe harbour criteria in PCG 2016/5 or be benchmarked with arm’s length evidence.

Having an LRBA that is not properly implemented and maintained can result in non-arm’s length income (NALI) and other potential contraventions of the Superannuation Industry (Supervision) Act 1993 (Cth).

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Relevant legislation

We will first examine the NALI provisions that can apply to a related-party LRBA in s 295-550(1) of the Income Tax Assessment Act 1997 (Cth) (ITAA 1997) which provides:

(1) An amount of ordinary income or statutory income is non-arm’s length income of a *complying superannuation entity if, as a result of a scheme the parties to which were not dealing with each other at arm’s length in relation to the scheme, one or more of the following applies:

(a) the amount of the income is more than the amount that the entity might have been expected to derive if those parties had been dealing with each other at arm’s length in relation to the scheme;

(b) in gaining or producing the income, the entity incurs a loss, outgoing or expenditure of an amount that is less than the amount of a loss, outgoing or expenditure that the entity might have been expected to incur if those parties had been dealing with each other at arms length in relation to the scheme;

(c) in gaining or producing the income, the entity does not incur a loss, outgoing or expenditure that the entity might have been expected to incur if those parties had been dealing with each other at arms length in relation to the scheme.

Latest ATO draft ruling on NALI

When an SMSF undertakes an LRBA and obtains more income, or where an SMSF trustee incurs a lower than arm’s length expense in relation to an arrangement (or does not incur any expense), the ATO would be keen to examine such arrangements to determine if there are any non-arm’s length dealings that resulted in increased income or lower expense.

Example 4 from the draft ruling LCR 2019/D3 provides an indication of how the ATO determines whether NALI should be applied to an LRBA.

Example 4 - purchase financed through a limited recourse borrowing arrangement on non-arm’s length terms – NALI

30. During the 2018-19 income year, Kellie, as trustee of her SMSF, entered into a non-commercial limited recourse borrowing arrangement (LRBA) with herself in her individual capacity to purchase a commercial property valued at $2 million. Her SMSF borrowed 100 per cent of the purchase price and the terms of the loan included interest being charged at a rate of 1.5 per cent per annum and repayments only being made on an annual basis over a 25-year period. Kellie’s SMSF received a commercial rate of rent from the property of $12,000 per month.

31. If Kellie’s SMSF had entered into an LRBA on arm’s length terms, it would be expected that repayments of principal and interest would have occurred on a monthly basis and interest would be charged on the LRBA at a commercial rate. The loan-to-market value ratio would have also not exceeded commercial levels.

32. For the purposes of subsection 295-550(1), the scheme involves the SMSF entering into the LRBA with Kellie, complying with the terms of the LRBA, purchasing the commercial property, and deriving the rental income. The terms of the LRBA constitute a non-arm’s length dealing between the SMSF and Kellie, which resulted in the SMSF incurring expenditure in gaining or producing rental income that was less than would otherwise be expected if those parties were dealing with each other at arm’s length in relation to the scheme. The rental income derived from the commercial property is therefore NALI.

33. The non-arm’s length expenditure incurred under the LRBA will also result in any capital gain that might arise from a subsequent CGT event happening in relation to the property (such as the disposal of the property) being NALI.

Paragraph 9 of LCR 2019/D3 states:

An amount of ordinary or statutory income will be NALI of a complying superannuation fund where:

  • there is a scheme in which the parties were not dealing with each other at arm’s length;
  • the fund incurs a loss, outgoing or expenditure of an amount in gaining or producing the income; and
  • the amount of the loss, outgoing or expenditure is less than the amount that the fund might have been expected to incur had those parties been dealing with each other at arm’s length in relation to the scheme.

Example 4 (quoted above) with a 100 per cent loan-to-value ratio (LVR), a 25-year loan with annual payments and a 1.5 per cent p.a. interest rate, appears more favourable to the fund compared to arm’s length terms.

It would be difficult for Kellie’s SMSF to support these terms with arm’s length benchmark evidence. Thus, the ATO’s view is that NALI would apply to any income from this arrangement (including any capital gain arising on a CGT event in relation to the property).

Comparing the hypothetical borrowing arrangement to the LRBA ‘scheme’

When determining whether NALI applies, TD 2016/16 states that an analysis of what the arm’s length borrowing terms would have been is required (“hypothetical borrowing arrangement”). It is then necessary to analyse whether it is reasonable to conclude that the SMSF trustee could have and would have entered into the hypothetical borrowing arrangement.

The ATO’s view is that, where it is reasonable to conclude that the SMSF trustee could not or would not have entered into the hypothetical borrowing arrangement, the income from the scheme will be treated as NALI.

The ATO also considers in TD 2016/16 that, where the SMSF trustee could have entered into the arrangement but derives more income compared to an arm’s length hypothetical borrowing arrangement, the income in relation to the scheme will also be taxed as NALI.

Following the introduction of the non-arm’s length expense provisions in s 295-550(1)(b) and (c) (quoted above) from 1 July 2018, the ATO would also seek to apply NALI where the expense in relation to the LRBA was less than a hypothetical borrowing arrangement (assuming the parties were dealing at arm’s length).

For example, in relation to Example 4 in LCR 2019/D3, if an arm’s length LRBA was charging 4.5 per cent interest (rather than 1.5 per cent) and was requiring principal and interest repayments on a monthly basis with a 70 per cent LVR, then the ATO would compare the factors set out in Table 1:

Table 1. Comparing a non-arm’s length LRBA with a hypothetical arm’s length arrangement

Item

Example 4 from LCR 2019/D3

Hypothetical arm’s length

Borrowing

$2,000,000

$2,000,000

LVR

100%

70%

Interest rate

1.5% p.a.

4.5% p.a.

Repayments

Annual

Monthly

Arm’s length rent

$144,000 p.a.

$144,000 p.a.

Annual interest*

$30,000

$63,000

Net (rent – interest)

$114,000

$81,000

Tax rate

45%

15%

Tax payable

$51,300

$12,150**

*Interest is based on an annual rate of interest without monthly compounding for simplicity.

**Tax of $12,150 is shown for the hypothetical arm’s length example to compare with the NALI example.

As can be seen from Table 1, the hypothetical arm’s length example would, when compared to the terms in Example 4, result in a much higher interest expense of $63,000 p.a. in year one compared to only $30,000 of interest under the facts in Example 4. Thus, the net rent after interest expense is $114,000 compared to $81,000 under the hypothetical arm’s length comparison.

This results in an additional $33,000 of income compared to the hypothetical arm’s length comparison, thereby giving rise to NALI under s 295-550(1)(b) ITAA 1997.

The onus is on the SMSF trustee to gather the relevant evidence to support the arm’s length nature of the arrangement.

ATO safe harbour on LRBAs

The ATO’s “safe harbour” for undertaking an LRBA, namely PCG 2016/5, has been an excellent ATO initiative, providing great practical guidance. Paragraph 2 of PCG 2016/5 states:

This Guideline sets out the “Safe Harbour” terms on which SMSF trustees may structure their LRBAs consistent with an arm’s length dealing. That is, for income tax compliance purposes, the Commissioner accepts that an LRBA structured in accordance with this Guideline is consistent with an arm’s length dealing and that the NALI provisions do not apply purely because of the terms of the borrowing arrangement.

Some of the key criteria that the ATO specifies to be within the safe harbour include interest rates, LVRs, the maximum loan period and security. LRBAs that satisfy the ATO safe harbour criteria will be taken to be consistent with an arm’s length dealing.

Broadly speaking, LRBAs that are consistent with arm’s length terms should not give rise to NALI. On the other hand, LRBAs that are not consistent with arm’s length terms may attract NALI.

It is important to note that many refer to non-arm’s length LRBAs as “related-party” LRBAs. However, some SMSFs have obtained loans from unrelated parties (such as friends and third parties that are not related parties) that still fall within the ATO’s definition of LRBAs that are not on arm’s length terms. That is, the terms of the arrangement have to be on arm’s length terms even where the parties are not related.

Funds entering into related-party LRBAs should seek to ensure that the terms of the LRBA fall within the safe harbour terms in PCG 2016/5, as this minimises the risk of the ATO asserting that the arrangement might be subject to NALI.

In certain cases, SMSFs may enter into LRBAs that do not comply with PCG 2016/5. This will place the onus on the SMSF trustee to obtain sufficient and appropriate evidence to support the arm’s length nature of the terms of the LRBA.

This may be difficult where there is no readily available market information that lenders will provide loans above an 80 per cent LVR or where an SMSF borrows to invest in a private unit trust. Evidence such as quotes and proposals from third parties, finance brokers and other sources can be obtained to support a fund’s position.

Tax payable if NALI is invoked

If NALI arises, an SMSF is subject to a 45 per cent tax rate that applies to the non-arm’s length income that is derived from the scheme after deducting any applicable expenses incurred in deriving that income.

Assuming that NALI was applied by the ATO in respect of the fund’s purchase of the property in Example 4 (quoted above), any net rental income derived from the property would be subject to a 45 per cent tax rate instead of the usual 15 per cent tax rate that usually applies to complying SMSFs. Table 1 illustrates the tax payable at 45 per cent compared to the usual 15 per cent tax rate. This could be critical if the rental income derived from the property is considerable.

Referring again to Example 4 above and Table 1, the entire $114,000 is subject to a 45 per cent tax rate, resulting in a tax liability of $51,300. It is important to note here that NALI can “taint” the entire income from the scheme and not just the additional income derived (i.e. not just the additional $33,000 of income compared to the hypothetical arm’s length example above).

For completeness, under NALI, a 45 per cent tax rate still applies to an SMSF deriving NALI even if the fund has one or more members in pension or retirement phase that would otherwise be covered by the pension exemption (e.g. where the fund was paying a pension when a member retired).

The ATO’s view is that, if NALI applies to the asset, the asset is generally tainted for the rest of its life, and any capital gain on a future disposal (or other CGT event) in respect of that asset is therefore also taxed as NALI. Therefore, in addition to a 45 per cent tax on net rental income from the property, a 45 per cent tax would also apply to any net capital gain in respect of the future sale or disposal of the property (after any applicable CGT discount, an SMSF is entitled to a one-third discount on an asset held for more than 12 months).

Note that NALI is an administrative matter rather than a “penalty” regime. The difficulty with NALI is that, once the arrangement is non-arm’s length, the ATO considers the entire net revenue and assessable capital gain on realisation of the asset is generally taxed at 45 per cent. This is why many refer to NALI as “nasty”.

Likely ATO review

Where an SMSF derives a relatively high income from its assets, it may be a candidate for a NALI review by the ATO. An ATO review can take considerable time and give rise to considerable professional costs due to the various ATO queries.

As noted above, the onus is on the taxpayer (i.e. the SMSF trustee) to prove that the ATO’s assessment is excessive. The legislation favours the revenue, which places the SMSF trustee (as taxpayer) at a significant disadvantage.

Having an LRBA which is not within the ATO safe harbour criteria, or which cannot be backed up with sufficient and appropriate benchmark arm’s length evidence, can therefore result in a detailed, time-consuming and costly review. We therefore recommend that expert advice is obtained where any NALI risk is involved.

SMSFs, LRBAs and NALI
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