On issuance of the Practical Guidance in June this year for related party borrowings, the ATO acknowledged that further information was needed.
Recently, the ATO released Tax Determination 2016/16 which dealt with the subject of when a limited recourse borrowing arrangement has not been entered into on arm’s length terms.
The core principal at the heart of the release of the information from the ATO is that all dealings between a related party of the SMSF and the SMSF must be on ‘commercial terms’, or ‘arm’s length’. The meaning of commercial terms or arm’s length in relation to obtaining a loan in an SMSF, is that the terms of the loan, ie the interest rate, amount borrowed and term of the loan, must reflect what can be obtained from a third party such as a banking institution.
An example taken directly from the ATO tax determination compares a non arm’s length LRBA and an Arm’s Length LRBA, provides the following example:
The SMSF purchased a commercial property;
Limited recourse borrowing arrangement is from a related party;
The property will be rented at $1,000 per week;
The SMSF had $25,000 in a bank account prior to the purchase of the property;
The ATO listed the Current LRBA details and a comparison borrowing arrangement:
In reviewing the loan situations, the ATO outlined the following issues:
- Under the Current LRBA, the SMSF did not have sufficient funds available to reduce the level of borrowings to a level that satisfies the 70% LVR – ie 100% of the property was financed and with only $25,000 in the SMSF bank account it was unlikely that a reduction of the loan could happen;
- The weekly rental would be unlikely to meet the repayments of both principal & interest using the guidance interest rate of 5.75%.
In identifying the issues with the current LRBA structure, the reasonable approach would be to review to assess if the current loan could be restructured to ensure compliance with the guidelines.
If unable to comply with guidelines, ie reducing LVR, payment of interest or reducing loan terms etc, where insufficient cash is available to reduce the loan amount as well as insufficient income being received to meet the increased loan repayment obligations, the ATO will review the arrangement to assess if it is Non Arm’s Length Income (NALI).
What does the ATO look for to assess NALI in an SMSF?
If the SMSF could not have or would not have acquired the commercial property under the hypothetical borrowing arrangement, the income that the SMSF would receive under the scheme if the parties were dealing with each other at arm’s length is nil.
Therefore, the $1,000 weekly income of rent received by the SMSF is NALI and will be taxed at 47%.