The ATO has set 30 June 2016 as the deadline for fixing related party limited recourse loans and having them on commercial terms. At the recent SMSF Practice conference in Sydney, an ATO spokesperson advised that they had flagged their concerns about Limited Recourse Borrowing Arrangements (LRBAs) with related parties (via ATO IDs 2014/39 & 2014/40) that were not structured on commercial terms.
“For some time now the ATO has flagged its concerns about LRBAs with related parties that are structured on non-commercial terms. However, the commissioner recognises that the review and restructure of these types of arrangements can take time,” an ATO spokesperson told SMSF Adviser.
In relation to what action the ATO will take against SMSFs with related party loans on non-commercial terms, SMSF Adviser reported that the ATO spokesperson said:
“Therefore, the commissioner will not allocate resources to undertaking any compliance activities or actions in relation to those arrangements provided commercial terms are in place by 30 June 2016. This time-frame is intended to allow funds sufficient time to further consider their particular circumstances and arrangements and, if necessary, to restructure arrangements on commercial terms without detriment.”
Whilst SMSFs with a non-commercial related party loan are now aware of the deadline for fixing the arrangement, the question is will this be long enough?
For related party loans, the focus has been on the interest rate, for example where the interest rate is below market or even zero. However, it is the whole loan arrangement that will have to be on commercial terms to avoid further investigation by the ATO. This includes the term of the loan, the loan to value ratio (LVR) and the repayment terms.
Effectively, the SMSF would, in our view, have to show that it could obtain a loan from an arm’s length lender on terms the same as those for the related party loan. Where this involves a reduction of the LVR, for example, and consequently requires a repayment of loan principal, how will the SMSF make this repayment by the deadline?
Let’s take the example in ATO 2014/40:
The SMSF borrowed from a related party under an LRBA as follows:
- Property acquired under the LRBA was a commercial property;
- The lender was the members of the SMSF in their personal capacity;
- The key features of the related party limited recourse loan was a follows:
- The amount borrowed is approximately $500,000.
- The loan term is 15 years.
- The Fund Trustee must make periodic monthly repayments of the loan principal. The periodic repayments will ensure that the loan principal is fully repaid by the end of the loan term.
- The interest rate is 0%.
- The amount borrowed under the loan was 80% (LVR) of the purchase price of the asset. Thus, given a loan of $500,000, the purchase price would have been $625,000.
- A mortgage in favour of the Lenders has been registered in respect of the asset.
- No personal guarantees or other security are given to the Lenders in relation to repayment of the loan.
Apart from the interest rate being below market, the other concern that the ATO had with the related party arrangement was that the LVR of 80% was not commercial, as evidence provided by the taxpayer was that the LVR from a commercial lender would be between 60% and 70%. It was noted that a higher LVR could be achieved where additional security from sources external to the fund are provided. However, the terms of the related party loan did not require or provide for such additional security.
So how could this arrangement comply with the 30 June 2016 deadline?
Firstly, the interest rate would need to be lifted so that it reflects a commercial rate for this type of loan. The loan agreement would require provisions to enable the change to the interest rate.
Secondly, as the terms of the loan do not provide for additional external security, the loan amount would need to be reduced such that the LVR fell within the 60% to 70% range, as per the evidence provided. This would require the SMSF to make a loan principal repayment of at least $62,500, assuming the market value of the property remains at $625,000, to reduce the LVR to the upper evidentiary threshold of 70%.
Will the SMSF have the funds to make the loan repayment by the 30 June 2016 deadline? What if the loan was on an LVR of 100% (as in ATO ID 2014/39)? The loan repayment required would be $187,500, making it harder for the SMSF to find the cash to make the loan repayment. Of course, one option would be for the members of the fund to make non-concessional contributions of the required amount, subject to contribution caps. The SMSF would then repay the members, in their capacity as the lender to the fund, resulting in a nil cash flow position for the members. However, where the members cannot fund the required non-concessional contribution then a temporary finance arrangement may be required – something that cannot be left to the last days prior to the deadline.
Alternatively, where the related party lender is a member of the SMSF, a forgiveness of part of the loan (equal to the require principal reduction amount) can achieve the same result. TR 2010/1, paragraph 36 notes that a contribution includes an increase of the fund’s capital “when a liability incurred by the superannuation provider is forgiven by the person to whom the liability is owed”.
The above scenario, to me, is a fairly straight forward one to fix by the deadline. However, I expect that there are many scenarios where compliance by the deadline will be more difficult, if not impossible. Take for example the following scenarios:
- SMSF borrowed under LRBA from commercial lender, however, there was a shortfall in funds to make acquisition. Shortfall was achieved via second limited recourse loan from related party. Which commercial lender will lend to an SMSF and rank second on the mortgage? This will most likely require the second loan to be repaid by 30 June 2016.
- The asset acquired under the LRBA is one that no commercial lender will lend on. Remember the days when no bank would lend to buy a child care centre or squash court centre?
- Related party lender has loaned monies for SMSF to acquire under LRBA a 50% interest in a property held as tenants in common with a related party. As we know, it is very difficult if not impossible to get a commercial lender to take a less than 100% security over an asset.
Should you believe you have an existing related party loan to your SMSF or have further questions please contact Chan & Naylor on either 1300 99 77 34 or firstname.lastname@example.org and implement a plan to resolve the issue before the ATO does allocate resources for compliance review activities.
Disclaimer: This article contains general information; before you make any financial or investment decision you should seek professional advice to take into account your individual objectives, financial situation and individual needs. Click for more detail regarding this disclaimer.