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SMSFs and related party borrowings: ATO waves a red flag on non-arm’s length arrangements

On 1 December 2015, the ATO released two interpretative decisions, ATO ID 2015/27 and ATO ID 2015/28, on limited recourse borrowing arrangements. The ATO has made clear its position that if a self managed superannuation fund (SMSF) enters into these arrangements, then all the relevant terms must reflect an arm’s length arrangement. Otherwise, the ATO’s view is that all the SMSF’s income from that arrangement will be assessed at the highest marginal rate.

The ATO’s interpretative decisions are a guide as to how the ATO will treat limited recourse borrowing arrangements (LRBAs) with related party lenders that are conducted on non-arm’s length terms. The ATO will only treat dealings as being on arm’s length terms if the arrangements reflect what might be expected to have occurred if the parties to the scheme had been dealing with each other at arm’s length.  For example, what terms would have been offered to the SMSF trustee by an unrelated third party lender?

When assessing whether an arrangement reflects an arm’s length arrangement, the ATO will assess:

  • the ordinary and statutory income which the SMSF actually derived from the arrangement

compared with

  • the ordinary and statutory income which the SMSF would have derived from the hypothetical arrangement which reflects what might have been expected to occur if the lender were unrelated.

What is a limited recourse borrowing arrangement or LRBA?

An SMSF trustee may only borrow money in limited circumstances, and subject to specific conditions.

Those circumstances include an LRBA which is governed by section 67A of the Superannuation Industry (Supervision) Act 1993 (SIS Act). Broadly speaking, this exception allows an SMSF trustee to:

  • borrow money from a lender (who may be a related party)
  • use that money to purchase a single asset (conditional on it being held in a separate trust, called a custody trust, until the loan is paid out in full)
  • grant the lender rights only over or in respect of that asset – not other assets of the SMSF (that is, the lender has ‘limited recourse’)
  • derive investment returns from the asset.

What is an arm’s length dealing vs. a non-arm’s length dealing?

An arm’s length dealing is a dealing between related parties which is on commercial terms, i.e. as if the other related party was in fact an unrelated party.

A non-arm’s length dealing is dealt with under subsection 295-550(1) of the Income Tax Assessment Act 1997 (the ITAA). Subsection 295-550(1) states that an amount of ordinary income or statutory income is non-arm’s length income of a complying superannuation fund derived by the entity in the capacity of beneficiary of a trust if:

  1. 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
  2. the amount of income 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.

When determining whether a dealing is arm’s length or non-arm’s length, the ATO may consider any connection between the SMSF (the borrower) and the lender, and any other relevant circumstances.

If the loan arrangements regarding the LRBA are deemed not to be an arm’s length dealing, then the arrangements will be treated as a scheme which generates non-arm’s length income, liable to be taxed at the highest marginal rate.

What is the ATO’s position?

The ATO released the two interpretative decisions, ATO ID 2015/27 and ATO ID 2015/28, following (and apparently in response to) the Tax and Superannuation Laws Amendment (2015 Measures No 2) Act 2015. This legislation introduced new ‘look-through’ provisions, which means all income and expenses arising from an LRBA are reported at the SMSF level and not at the custody trust (bare trust) level.

The ATO’s position is that non-arm’s length income provisions can apply when an SMSF trustee undertakes an LRBA on terms which are deemed not to be on arm’s length terms.

The result of an LRBA being a non-arm’s length dealing is that the income will be subject to tax at the highest marginal tax rate, as opposed to the concessional rate of 15 percent. This penalty rate applies even if a fund is in pension mode and would otherwise pay no tax on pension earnings.

The ATO makes reference to the test expressed in the Full Federal Court decision in Allen,[1] where the Court explained a comparison is required between:

  • the ‘hypothetical situation’ which is what ‘might have been expected to apply if the parties had been dealing at arm’s length’
  • the ‘actual dealing’ between the related parties.

The ATO’s position, as expressed through the above interpretative decisions, is that the statutory income which the SMSF might be expected to derive from the hypothetical situation is nil.

This is because:

  • the ATO takes the view that an arm’s length lender would not normally lend capital on the terms that form part of the actual arrangement (that is, the terms actually agreed between the related parties)
  • without the loan, it might be expected that there would be no investment in the asset through the custody trust and therefore no ordinary or statutory income would be expected to be derived by the SMSF from that asset.

In other words, if the loan terms of an LRBA with a related lender are found not to be arm’s length, the ATO’s view is that all of the earnings derived by the SMSF from the asset (for example, all of the rental income, in the case of an investment property) are to be taxed at the highest marginal tax rate.

Is there an alternative view?

As is borne out in the interpretative decisions, the use of the words might have been expected strongly suggests the relevant test that should be applied for the purposes of subsection 295-550(1) is a comparison between the income actually derived by the SMSF and the income the SMSF might have been expected to derive in the hypothetical or counterfactual situation if those parties had been dealing with each other at arm’s length.

There is an alternative view for the ‘counterfactual’ situation that:

  • the analysis requires a prediction as to the events which would have taken place if the non-arm’s length element of the arrangement had not been entered into and carried out
  • if there was more than one event that could have taken place, the comparison counterfactual would be the event that was more probable than not: such analysis is not dissimilar to the approach adopted by the High Court in determining whether or not there was a tax benefit for the purposes of Part IVA of the ITAA 1936[2]
  • two scenarios which should be evaluated on that basis are:
    • that the loan would not have been made at all – the ATO’s view
    • that the loan would have been made on different terms – the alternative view.

It is evident from the interpretative decisions that the ATO’s counterfactual is that nothing would have happened. Simply put, because the SMSF would not have been able to source the loan on those terms, the asset purchase would not have taken place. The ATO adds:

It is no answer to say that the SMSF could have obtained a loan from an arm’s length lender on different terms or that the SMSF could have used other means to acquire the assets, as that is not the scheme into which the parties have entered.

In our view a ‘do nothing’ counterfactual is completely unreasonable as it assumes the whole purpose of the arrangement was to obtain, for example, an interest-free loan. The reality is that, in the vast majority of situations, the dominant purpose of the arrangement will be the acquisition of the relevant asset. When one views the arrangement this way, it is apparent that if those parties were acting at arm’s length then – as occurs daily in arm’s length commercial dealings – it is more likely than not the loan terms would have been negotiated, and the SMSF would still have acquired the asset, albeit supported by a loan on different terms.

It is also apparent this type of analysis better reflects that required by the legislation, namely ‘the amount of income that the SMSF might have been expected to derive’.

What are the impacts for existing LRBAs? Are there things to be careful of? 

The ATO may scrutinise LRBAs closely to ensure arrangements that present as being arm’s length, actually are. The ATO will look at the following facts closely:

  • the relationship between the members of the SMSF, the directors of the corporate trustee (if applicable), the borrower and the lender
  • the total amount borrowed as a percentage of the asset’s value (i.e. the loan-to-value ratio)
  • the term of each loan
  • the conditions of repayment
  • the interest rate
  • the lender’s rights against the borrower or the custody trust trustee in relation to a default.

SMSF trustees should review their LRBAs to determine whether they were established and maintained on terms consistent with an arm’s length dealing. If you are unsure, you should seek legal and professional advice by a qualified provider, or request a private ruling to ensure the terms of your LRBA are appropriate.

In particular, seek advice if you have an LRBA with any of the following terms:

  • 0 percent or a low, non-commercial interest rate
  • a high loan-to-value ratio
  • single lump sum repayment at the end of the loan term rather than regular, periodic repayments.
Author
Stephanie McLennan 1cm 300ppi BW JPG 2014 Stephanie McLennan | Lawyer
Tel +61 3 9258 3398
E stephanie.mclennan@maddocks.com.au

____________________________

[1] Allen v Federal Commissioner of Taxation (2011) 195 FCR 416;2011 ATC 20-277; (2011) 84 ATR 853
[2] FCT v Peabody 94 ATC 4663 and Commissioner of Taxation v Hart and Another 206 ALR 207

On 1 December 2015, the ATO released two interpretative decisions, ATO ID 2015/27 and ATO ID 2015/28, on limited recourse borrowing arrangements. The ATO has made clear its position that if a self managed superannuation fund (SMSF) enters into these arrangements, then all the relevant terms must reflect an arm’s length arrangement. Otherwise, the ATO’s view is that all the SMSF’s income from that arrangement will be assessed at the highest marginal rate.

The ATO’s interpretative decisions are a guide as to how the ATO will treat limited recourse borrowing arrangements (LRBAs) with related party lenders that are conducted on non-arm’s length terms. The ATO will only treat dealings as being on arm’s length terms if the arrangements reflect what might be expected to have occurred if the parties to the scheme had been dealing with each other at arm’s length.  For example, what terms would have been offered to the SMSF trustee by an unrelated third party lender?

When assessing whether an arrangement reflects an arm’s length arrangement, the ATO will assess:

  • the ordinary and statutory income which the SMSF actually derived from the arrangement

compared with

  • the ordinary and statutory income which the SMSF would have derived from the hypothetical arrangement which reflects what might have been expected to occur if the lender were unrelated.

What is a limited recourse borrowing arrangement or LRBA?

An SMSF trustee may only borrow money in limited circumstances, and subject to specific conditions.

Those circumstances include an LRBA which is governed by section 67A of the Superannuation Industry (Supervision) Act 1993 (SIS Act). Broadly speaking, this exception allows an SMSF trustee to:

  • borrow money from a lender (who may be a related party)
  • use that money to purchase a single asset (conditional on it being held in a separate trust, called a custody trust, until the loan is paid out in full)
  • grant the lender rights only over or in respect of that asset – not other assets of the SMSF (that is, the lender has ‘limited recourse’)
  • derive investment returns from the asset.

What is an arm’s length dealing vs. a non-arm’s length dealing?

An arm’s length dealing is a dealing between related parties which is on commercial terms, i.e. as if the other related party was in fact an unrelated party.

A non-arm’s length dealing is dealt with under subsection 295-550(1) of the Income Tax Assessment Act 1997 (the ITAA). Subsection 295-550(1) states that an amount of ordinary income or statutory income is non-arm’s length income of a complying superannuation fund derived by the entity in the capacity of beneficiary of a trust if:

  1. 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
  2. the amount of income 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.

When determining whether a dealing is arm’s length or non-arm’s length, the ATO may consider any connection between the SMSF (the borrower) and the lender, and any other relevant circumstances.

If the loan arrangements regarding the LRBA are deemed not to be an arm’s length dealing, then the arrangements will be treated as a scheme which generates non-arm’s length income, liable to be taxed at the highest marginal rate.

What is the ATO’s position?

The ATO released the two interpretative decisions, ATO ID 2015/27 and ATO ID 2015/28, following (and apparently in response to) the Tax and Superannuation Laws Amendment (2015 Measures No 2) Act 2015. This legislation introduced new ‘look-through’ provisions, which means all income and expenses arising from an LRBA are reported at the SMSF level and not at the custody trust (bare trust) level.

The ATO’s position is that non-arm’s length income provisions can apply when an SMSF trustee undertakes an LRBA on terms which are deemed not to be on arm’s length terms.

The result of an LRBA being a non-arm’s length dealing is that the income will be subject to tax at the highest marginal tax rate, as opposed to the concessional rate of 15 percent. This penalty rate applies even if a fund is in pension mode and would otherwise pay no tax on pension earnings.

The ATO makes reference to the test expressed in the Full Federal Court decision in Allen,[1] where the Court explained a comparison is required between:

  • the ‘hypothetical situation’ which is what ‘might have been expected to apply if the parties had been dealing at arm’s length’
  • the ‘actual dealing’ between the related parties.

The ATO’s position, as expressed through the above interpretative decisions, is that the statutory income which the SMSF might be expected to derive from the hypothetical situation is nil.

This is because:

  • the ATO takes the view that an arm’s length lender would not normally lend capital on the terms that form part of the actual arrangement (that is, the terms actually agreed between the related parties)
  • without the loan, it might be expected that there would be no investment in the asset through the custody trust and therefore no ordinary or statutory income would be expected to be derived by the SMSF from that asset.

In other words, if the loan terms of an LRBA with a related lender are found not to be arm’s length, the ATO’s view is that all of the earnings derived by the SMSF from the asset (for example, all of the rental income, in the case of an investment property) are to be taxed at the highest marginal tax rate.

Is there an alternative view?

As is borne out in the interpretative decisions, the use of the words might have been expected strongly suggests the relevant test that should be applied for the purposes of subsection 295-550(1) is a comparison between the income actually derived by the SMSF and the income the SMSF might have been expected to derive in the hypothetical or counterfactual situation if those parties had been dealing with each other at arm’s length.

There is an alternative view for the ‘counterfactual’ situation that:

  • the analysis requires a prediction as to the events which would have taken place if the non-arm’s length element of the arrangement had not been entered into and carried out
  • if there was more than one event that could have taken place, the comparison counterfactual would be the event that was more probable than not: such analysis is not dissimilar to the approach adopted by the High Court in determining whether or not there was a tax benefit for the purposes of Part IVA of the ITAA 1936[2]
  • two scenarios which should be evaluated on that basis are:
    • that the loan would not have been made at all – the ATO’s view
    • that the loan would have been made on different terms – the alternative view.

It is evident from the interpretative decisions that the ATO’s counterfactual is that nothing would have happened. Simply put, because the SMSF would not have been able to source the loan on those terms, the asset purchase would not have taken place. The ATO adds:

It is no answer to say that the SMSF could have obtained a loan from an arm’s length lender on different terms or that the SMSF could have used other means to acquire the assets, as that is not the scheme into which the parties have entered.

In our view a ‘do nothing’ counterfactual is completely unreasonable as it assumes the whole purpose of the arrangement was to obtain, for example, an interest-free loan. The reality is that, in the vast majority of situations, the dominant purpose of the arrangement will be the acquisition of the relevant asset. When one views the arrangement this way, it is apparent that if those parties were acting at arm’s length then – as occurs daily in arm’s length commercial dealings – it is more likely than not the loan terms would have been negotiated, and the SMSF would still have acquired the asset, albeit supported by a loan on different terms.

It is also apparent this type of analysis better reflects that required by the legislation, namely ‘the amount of income that the SMSF might have been expected to derive’.

What are the impacts for existing LRBAs? Are there things to be careful of? 

The ATO may scrutinise LRBAs closely to ensure arrangements that present as being arm’s length, actually are. The ATO will look at the following facts closely:

  • the relationship between the members of the SMSF, the directors of the corporate trustee (if applicable), the borrower and the lender
  • the total amount borrowed as a percentage of the asset’s value (i.e. the loan-to-value ratio)
  • the term of each loan
  • the conditions of repayment
  • the interest rate
  • the lender’s rights against the borrower or the custody trust trustee in relation to a default.

SMSF trustees should review their LRBAs to determine whether they were established and maintained on terms consistent with an arm’s length dealing. If you are unsure, you should seek legal and professional advice by a qualified provider, or request a private ruling to ensure the terms of your LRBA are appropriate.

In particular, seek advice if you have an LRBA with any of the following terms:

  • 0 percent or a low, non-commercial interest rate
  • a high loan-to-value ratio
  • single lump sum repayment at the end of the loan term rather than regular, periodic repayments.
Author
Stephanie McLennan 1cm 300ppi BW JPG 2014 Stephanie McLennan | Lawyer
Tel +61 3 9258 3398
E stephanie.mclennan@maddocks.com.au

____________________________

[1] Allen v Federal Commissioner of Taxation (2011) 195 FCR 416;2011 ATC 20-277; (2011) 84 ATR 853
[2] FCT v Peabody 94 ATC 4663 and Commissioner of Taxation v Hart and Another 206 ALR 207