SMSF LRBA: 0% Interest can equal 45% Tax

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PercentThe ATO has recently issued a Private Binding Ruling which casts some doubt on 0% interest-rate limited-recourse borrowing arrangements (LRBAs). Should this interpretation be correct SMSFs with LRBAs at 0%, or indeed below-market rates of interest, could owe 45% tax on income relating to the LRBA Investment. Since 2010, based on a number of binding and non-binding ATO sources, there has been increasing comfort with the SIS compliance of related-party LRBAs, including at below-market rates of interest. This broader interest came as a result of minutes of the National Tax Liaison Group (NTLG) Superannuation Technical Sub-group meeting in June 2012, where the ATO said that such an arrangement could be consistent with s67A and s109:

“Yes. A lower than market interest rate or the absence of a requirement to pay interest on money loaned to the trustee by a related party will not prevent the arrangement from being a borrowing for the purposes of section 67A of the SISA”

“a fact that the borrowing is interest free does not cause a contravention of paragraph 109(1)(b) of the SISA as that fact does not make the terms and conditions of the borrowing more favorable to the related party lender than would be reasonably expected if the parties were dealing with each other at arm’s length in the same circumstances.”

It should be noted that the NTLG minutes are not binding on the ATO or other participants.

Further support was lent to this strategy by ATO ID 2010/162, which said that a LRBA which involved money being lent to a SMSF on terms more favorable to the fund than market rates would not be a breach of s109. As this was an Interpretative Decision it carried with it greater protection than the NTLG minutes.

However you may have noticed that both these sources only consider the implications of the borrowing provisions and the arm’s length investment rules on a LRBA – not how the non-arm’s length income rules of s295-550 of the ITAA 97 may apply. Which brings us to the latest ATO Public Binding Ruling: Authorisation Number: 1012582301006.

It is important to remember this is a Private Binding Rulings, and while they are informative, they are only binding on the ATO in respect of the entity covered by the ruling. The full text of the Private Binding Ruling Disclaimer is:

“You cannot rely on the rulings in the Register of private binding rulings in your tax affairs. You can only rely on a private ruling that we have given to you or to someone acting on your behalf.
The Register of private binding rulings is a public record of private rulings issued by the ATO. The register is an historical record of rulings, and we do not update it to reflect changes in the law or our policies.The rulings in the register have been edited and may not contain all the factual details relevant to each decision. Do not use the register to predict ATO policy or decisions.”

The ruling involves a fairly standard SMSF LRBA structure. a SMSF with a corporate trustee, with a separate corporate trustee for the custodian trust. In the ruling a family trust controlled by the members of the SMSF will lend an amount of money to the SMSF for the purchase of listed shares via a custodian trust. The loan will be made as two or more loans, with a separate loan for each asset to be purchased.

The repayment terms are broad, allowing for:

  • repayment as a single lump-sum at the end of an unspecified term
  • repayment earlier as agreed between the borrower and lender
  • prepayment of all or part of the loan, without penalty, as agreed between the borrower and lender
  • The rate of interest on the loan will be 0%

s295-550 of the Income Tax Assessment Act 1997 determines certain income to be Non-Arm’s Length Income and is taxed at 45%, instead of the normal rate for an SMSF. This 45% still applies in pension phase, as non-arm’s length income is excluded from ECPI. The text of s295-550(1)  is:

“An amount of ordinary income or statutory income is non-arm’s length income of a complying superannuation fund, a complying approved deposit fund or a pooled superannuation trust (other than an amount to which subsection (2) applies or an amount derived by the entity in the capacity of beneficiary of a trust) if:
(a) it is derived from a scheme the parties to which were not dealing with each other at arm’s length in relation to the scheme; and
(b) that amount 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.”

In the ruling the ATO determines that the arrangement is a Scheme and that the parties have not death with each other at arm’s length, giving the following reasons:

  • the lender is not compensated for the risk or opportunity cost of the loan
  • payment by lump-sum instead of periodic principal repayments
  • 100% LVR, as opposed to the market LVRs applying to LRBAs
  • no requirement for personal guarantees by members of the fund
  • limited protection for the lender, including lack of security

The ATO then goes on to determine that the amount the SMSF would expect to earn from the arrangement is greater than under an arm’s length arrangement, as either the SMSF would not be able to borrow the money on such terms, or the SMSF would be able to borrow less than 100% of the purchase price. As such the ATO deems the income resulting from the LRBA to be non-arm’s length income and it would be taxed at 45%.

However this ruling appears to be at odds with two earlier ATO Private Binding Rulings regarding 0% interest loans and LRBAs, which said that such arrangements (based on the situations as set out in the individual rulings) would not be taxed as non-arm’s length income:

It is unclear at this stage if there has been a change of the ATO’s opinion or a continuation of interpretation of the SISA/SISR that has only emerged now due to the limited number of cases presented to the ATO.

The ruling also discusses two other aspects of a 0% interest LRBA, however these parts are in-line with previous publications:

Does the discount on the interest represent a contribution?

The ATOs view in this Private Binding Ruling, that the discount on the interest rate does not give rise to a contribution,  is constant with the view expressed in the NTLG minutes:

“The absence of a requirement to pay interest on money loaned to the trustee does not increase the capital of the fund. A saving on an expense of an SMSF in the circumstances described is analogous to the circumstances outlined in examples 2 and 5 in Taxation Ruling TR 2010/1 Income tax: superannuation contributions. The purpose of a person in offering a low interest loan to an SMSF does not fall for consideration if there has been no increase in the capital of the fund”

If the sale of the asset is less than the loan balance, is there a contribution?

The ATO also considers whether there has been a contribution where the proceeds from the sale of the asset are less than the outstanding loan balance. Under such a limited-recourse loan the lender is only able to recover the amount of the loan against the asset purchased with the loan (leaving aside any issues where multiple assets are purchased in the same custodian trust). The ATO says in the ruling that in such a situation there has not been a forgiveness of the loan, but that the lender has “pursued their rights to the full extent available under the loan arrangement.” Therefore as there has been no increase in the capital of the fund there is no contribution, as per para. 180 of TR 2010/1, :

“Similarly, the capital of the fund would not be increased when a lender exercises their right of recourse against the asset in circumstances where the value of the asset is less than the amount outstanding on the loan. This will be so even if the lender exercises both the right of recourse against the asset and requires a guarantor to satisfy any difference between the value of the asset and the outstanding loan amount.”

Note that this is not a consideration of the result if the loan was forgiven, or where 3rd party guarantees  are triggered as the result of a shortfall in the proceeds of the sale of the asset under a LRBA.

Given the trend in ATO thinking on the matter people considering a lower-than-market rate LRBA may wish to apply for a Private Binding Ruling before entering into a lower than market rate LRBA. Hopefully there will be a ruling covering such issues in the near future to provide certainty.

 

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