The ATO has issued a new Taxation Determination, TD 2016/16, setting out when a non-arm’s length Limited Recourse Borrowing Arrangement could result in Non-Arm’s Length Income.
The ATO has also withdrawn two earlier Interpretative Decisions, ATO ID 2015/27 and ID 2015/28, which dealt with Non-Arm’s Length Income (NALI), as “issue is now covered by Taxation Determination TD 2016/16.”
Since these earlier Interpretative Decisions were issued the ATO has published PCG 2016/5, which sets out a safe-harbour for SMSFs with Limited Recourse Borrowing Arrangements (LRBAs) from NALI. The ATO has also given SMSFs until 31 January 2017 to review potentially non-arm’s length LRBAs.
TD 2016/16 says:
When parties to a scheme, that include a trustee of a self-managed superannuation fund (SMSF), have entered into a limited recourse borrowing arrangement (LRBA) on terms which are not at arm’s length, it is necessary to consider whether the SMSF has derived more ordinary or statutory income under the scheme than it might have been expected to derive if the parties had been dealing with each other at arm’s length in relation to the scheme. Non-arm’s length income (NALI) will only arise in those cases where the answer to this question is affirmative.
The TD contains an example comparing an LRBA with a hypothetical borrowing arrangement. The ‘current LRBA’ involves 100% LVR at 0% interest over a 25 year period with no repayments until the end of the loan. The ATO compares this to a hypothetical borrowing arrangement of 70% LVR, with monthly payments of principal and interest, at variable rates, over 15 years.
The ATO says “it is clear that the SMSF could not and would not have entered into the arm’s length hypothetical borrowing arrangement”. This is because the SMSF did not have sufficient assets to reach a 70% LVR, and the arrangement would not have been “earnings accretive”.
“Because the SMSF could not have and would not have acquired the commercial real property under the hypothetical borrowing arrangement, the income that the SMSF would be expected to derive from the scheme if the parties were dealing with each other at arm’s length is nil. If the parties were dealing with each other at arm’s length in relation to the scheme the investment in the commercial real property would not occur, as no arm’s length LRBA could have been entered into.”
As such, the ATO says the full amount of the rent received on the property is NALI.
Note that TD 2016/16 is a public ruling, and as such provides a degree of protection to taxpayers that rely on it, as set out in the preamble.
SMSF Association gives ruling “thumbs up”
The SMSF Association has welcomed the ATO ruling, with CEO Andrea Slattery saying it will be “extremely helpful” to SMSF professionals advising clients on this complex issue.
“With issues such as LRBAs and the possible tax implications, the SMSF Association is always pleased and supportive when the ATO provides determinations that assist in clarifying what can be grey areas in relation to tax.”
“What the ATO determination highlights is the complexity around LRBAs, and this is why the Association urges SMSF trustees and members to seek specialist advice when considering using this investment option.”
“In most instances, SMSF specialists are the only advisors with the necessary skill set to understand all the implications around LRBAs, and we would urge all fund members to take advantage of their knowledge to ensure they get the best possible advice.”