In 2016, the ATO released compliance guidelines for related party limited recourse borrowing arrangements (LRBAs). This article reviews the Practical Compliance Guidelines (PCG 2016/5) and considers their ramifications.

Background

In November 2015, the ATO updated its Interpretative Decisions on limited recourse borrowing arrangements and non-arm's length income (NALI), when it released IDs 2015/27 and 2015/28.

Those IDs include examples of non-commercial arrangements which would result in the income derived from the asset, purchased under the limited recourse borrowing arrangement, being deemed to be NALI (and taxed at the top marginal rate).

The writer, when covering those IDs in webinars, referred to them as the ‘unfortunate IDs’. Each of the examples included in those IDs had zero interest rate loans, which we already knew would result in NALI determinations. The unfortunate aspect was that there was no indication, had the interest been at a commercial rate, whether any other components of the examples would trigger NALI.

The suggestion therefore was that it would be beneficial for the ATO to outline what would be acceptable, so that Trustees, their advisers, tax agent and auditor of their SMSF could be clear when determining whether or not the arrangements were on arm’s length terms.

Bearing in mind the often used phrase ‘be careful what you wish for’, let's consider the ATO guidelines and the implications for Trustees and their advisers.

Practical Compliance Guidelines 2016/5

In PCG 2016/5, the ATO has provided what it calls a ‘Safe Harbour’ for related party LRBAs. In other words, if the terms of the arrangement match those provided within the Safe Harbour guidelines, the Commissioner will accept that the LRBA is consistent with an arm's-length dealing, removing the possibility of a NALI determination.

Conversely, if SMSF Trustees have an LRBA with a related party loan, the terms of which do not sit within the Safe Harbour guidelines, it does not automatically mean that the income generated from the investment will be NALI. It does mean, however, that there is no certainty as to whether or not NALI will apply.

Safe Harbours

The ATO provided two examples of the various components of a related party LRBA within the Safe Harbours in the PCG, which are summarised (and updated) in the table below:

Components	Safe Harbour # 1	Safe Harbour # 2
Asset	Real Property1	Listed Shares or Units
Interest Rate2	RBA Indicator Lending Rates for banks providing standard variable housing loans for investors: - for 2015/16 - 5.75% - for 2016/17 - 5.65% - for 2017/18 - 5.80% - for 2018/19 - 5.80% - for 2019/20 - 5.94% - for later years, the rate published in May for the following financial year	RBA Indicator Lending Rates for banks providing standard variable housing loans for investors + 2%: - for 2015/16 - 7.75% - for 2016/17 - 7.65% - for 2017/18 - 7.80% - for 2018/19 - 7.80% - for 2019/20 - 7.94% - for later years, the rate published in May (+ 2%) for the following financial year
Fixed/Variable Interest	May be Fixed or Variable Variable Interest Applicable rate as above Fixed Interest May be fixed - maximum 5 years, using the RBA May rate, as above	May be Fixed or Variable Variable Interest Applicable rate as above Fixed Interest May be fixed - maximum 3 years, using the RBA May rate, as above, + 2%
Term of Loan3	15 year maximum If refinancing, 15 years includes period of the former loan	7 year maximum If refinancing, 7 years includes period of the former loan
Loan to Value Ratio (LVR)1	Maximum 70% LVR (all loans combined) Value established at commencement of loan	Maximum 50% LVR (all loans combined) Value established at commencement of loan
Security	Registered Mortgage	Registered Charge/Mortgage
Personal Guarantee	Not Required	Not Required
Nature and Frequency of Repayments4	Monthly - Principal and Interest	Monthly - Principal and Interest
Loan Agreement	Written & Executed Agreement	Written & Executed Agreement

Notes:

¹	Unlike with bank lenders, there is no distinction between residential and commercial property
²	Loan agreements will need to provide for the ability of the lender to notify the borrower of the new rate, and the monthly instalment amounts, for (if rate not fixed) the following year
³	If refinancing, care needs to be taken to reduce the period of the new loan from the 15 year/7 year maximum to take into account the period the loan being replaced has been in existence. Similarly, the 5 year/3 year fixed interest rate terms would need to be adjusted
⁴	Interest Only loans are not included under the Safe Harbour guidelines

Action required - existing LRBAs

The ATO provided two examples (now somewhat dated) in PCG 2016/5 of steps which Trustees should consider, one for real property
and one for listed shares, if they wish to ensure their LRBAs meet the Safe Harbour guidelines, with a number of options considered under each example.

# 1 - Real Property example
In the scenario outlined by the ATO, the LRBA circumstances are:

Components	Details
Lender	Related party
Loan Amount	$500,000
Asset Value	$643,000 (1 July 2015)
Loan to Value Ratio (LVR)	78% ($500,000 ÷ $643,000)
Loan Commencement	1 July 2011 (i.e. 4+ years)
Term of Loan	25 years
Interest Rate	0%
Nature and Frequency of Repayments	Principal at end of term (or earlier at borrower’s discretion - not so far exercised)
Loan Agreement	Written agreement

The three possible options suggested by the ATO in the example, to avoid a NALI determination, are:

Option # 1	Option # 2	Option # 3
Alter terms	Commercial lender	Clear loan
1. Repay $49,900 (i.e. reduce LVR to 70%)	1. Refinance with commercial lender	1. Repay the loan
2. Reduce remaining term to 11 years from 1 July 2015 (4 years from commencement)	2. Ensure interest & principal are paid for the 2015/16 year (until refinanced)	2. Ensure interest is paid from 1 July 2015 until loan is cleared (repayment will meet principal requirements)
3. Alter interest terms of loan to fixed rate (5 years) or variable rate
4. Set interest rate at 5.75% from 1 July 2015 to 30 June 2016
5. Ensure interest is paid for the 2015/16 year ($49,900 payment likely to cover principal requirements)
6.From 1 July 2016 ensure: - interest rate adjusted; & - monthly payment of interest & principal

Note: the ATO also included three options for dealing with the loan arrangements for listed shares or units, with the options virtually a replica of the options available for real property as detailed above.

Although the ATO example is dated, the options listed still have relevance for those SMSFs with LRBAs which have been deemed to have, or are likely to have, a NALI assessment.

Not meeting the Safe Harbour guidelines

PCG 2016/5 is merely a set of guidelines which Trustees may wish to apply to their LRBAs which have related party loans. There is no compulsion on Trustees to meet the guidelines but, if the terms of their arrangements are outside the guidelines, they risk the imposition of NALI on the income (and realised capital gains) derived from the investment.

Whilst it is not certain that NALI would automatically apply outside of the guidelines, it is clear that some other determination would be needed to avoid imposition of the higher tax rate. Under the self-assessment regime, the Trustee of the SMSF and the tax agent lodging the SMSF annual return will need to determine:

• whether NALI applies; and, if not
• on what basis they arrived at that reasoning.

Benchmarking

One very valid reason why Trustees may decide that NALI does not apply, despite not meeting the Safe Harbour guidelines, is because they have benchmarked their loan against what is on offer commercially.

However, with benchmarking, it is very important to match like with like. For example, if we look at the ATO Safe Harbour # 2 example (listed securities) and, assuming that the benchmarking was against the terms an individual could obtain by drawing on their home loan, it is unlikely that the comparison would be considered a reasonable example of benchmarking. In reality, the safest method to avoid the application of NALI, other than matching the Safe Harbour guidelines, would be to obtain approval for a loan from a commercial lender and apply those terms to a related party loan.

However, when we consider that in many instances the related party loan occurs because of difficulties in obtaining commercial finance, such benchmarking is not going to be a simple exercise. In those scenarios, it would be wise for Trustees to consider matching the guidelines which provide the Safe Harbour.

Top up Loans

The Safe Harbour guidelines, in relation to the LVR, include limits for both real property and listed shares and units of 70% and 50%, respectively. Those LVRs relate to all loans applied to purchase the asset.

In a number of instances, where the amount available from a commercial lender is insufficient to enable the Trustee to acquire the asset, a secondary loan may be provided by a related party to enable completion of the purchase.

Often, that secondary loan will put the combined LVR in excess of the Safe Harbour guidelines, meaning that there is a risk of NALI because of that top up loan. Once again, Trustees should consider whether they can repay the top up loan, either using available funds or by refinancing with a commercial lender, or a combination of the two.

Unit Trusts

Other than the consideration provided to listed Unit Trusts, the ATO has not provided any Safe Harbour guidelines in respect of Unit Trusts, such as unlisted (widely held) trusts and, more particularly, SIS Reg 13.22C trusts which, in our reckoning, are the second largest asset type for related party LRBAs.

Although loans for Unit Trusts may still proceed under LRBAs, the provisions contained in the guidelines make benchmarking even more important for such arrangements.

Conclusion

We now have guidelines which we asked for - whether they are what we wished for remains to be seen. A major benefit is that Trustees and their advisers now have a clear indication as to what is required to ensure that NALI does not apply to at least some investments.

A negative is that the terms are somewhat onerous, and not all possible investments are covered under the existing guidelines.

For those Trustees who have LRBAs which do not meet the guidelines, they will need to rectify the arrangements, if they decide to use the Safe Harbour guidelines.

That includes refinancing or restructuring the loan documentation as well as ensuring the principal and interest requirements are met.

Topdocs is available to assist with any documentation required to enable Trustees to reach their Safe Harbour.

Please note this article is for information purposes only and does not constitute legal advice. Should you have any queries or require more information, please contact the team at Topdocs on 1300 659 242.

Download the Related Party Borrowing by SMSFs - The ATO’s ‘Safe Harbour’ Guidelines explained article