The SMSF Club | Non-Arms Length Limited Recourse Borrowing Arrangements Alert
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Non-Arms Length Limited Recourse Borrowing Arrangements Alert

03 Mar Non-Arms Length Limited Recourse Borrowing Arrangements Alert

This week’s technical update will cover: Non-Arms Length Limited Recourse Borrowing Arrangements Alert.

What is Non-Arms Length Income

This refers to the situation where a SMSF enters into a transaction with a related party and as a result receives higher income than it would have if dealing with an arms length parties. Any such income received by a SMSF trustee is then taxed at the top marginal rate of 45% rather than the concessional rate which apply to income of a complying SMSF which is 15%.

If income is considered to be non-arms length, it is the whole of the income received by the SMSF not just the excess over what would have been received in an arm’s length transaction that is non-arms length income.

How the Rules Apply To Limited Recourse Borrowing Arrangements

In late 2012 the ATO indicated that it was possible for related parties lending to SMSFs for limited recourse borrowing arrangements (LRBAs) to charge a nil interest rate. In all these cases it is clear that there is an arrangement or scheme and that the parties are not dealing with each other at arms length because no commercial lender would make a Nil interest rate loan.

In these circumstances, it is arguable that the trustee of the SMSF is receiving income greater than it would if the parties were dealing at arms length because there is no interest rate expense to be paid.

Initially, the ATO confirmed that the non-arms length income rules will not apply to a SMSF where it saves on an interest rate expense in a LRBA.

ATO Current View

The ATO has now completely changed their view in relation to how the non-arms length income rules apply to LRBAs.

The ATO now states that the income received by the SMSF would be less in an arms length transaction and that the SMSF would not receive any income at all as it would not have entered into the LRBA on commercial terms. Whether this last statement is correct or not is another issue. This is the ATO’s position now.

The reason the income would be less is because of the requirement to repay a commercial rate of interest on the loan in an arms length transaction.

Consequences for SMSFs Entering Into New LRBAs or Refinancing LRBAs

As a result of this change of view by ATO, all future LRBAs involving related parties must be on commercial terms. This means not only must the interest rate be similar to what a typical bank lender would charge but also the other terms required by a typical commercial lender must be included. Such terms or conditions usually include:

  1. The length of the loan,
  2. Whether principal & interest is charged,
  3. Repayment frequency of interest and principal if principal is being repaid,
  4. The loan- to- value ratio so no 100% loans would be applicable,
  5. The rights of the lender if borrower defaulted and
  6. The security provided for the loan including registration of such security.

ATO Amnesty on Non-Commercial Loans

The ATO has announced that all SMSFs currently with non-arms length LRBAs must deal with these as soon as possible and by 1 July, 2016 at the latest.

This means any trustee of a SMSF with a non- arms-length LRBA should seek professional advice immediately so that they have time to refinance their loans if the loans are not on commercial terms or wind up the transaction before this deadline is reached which is only a few months away.

Conclusion

If a trustee of a SMSF does not take steps to rectify any non-arms length LRBA by this deadline then any rental income received after this date will be subject to a tax rate of 45% and not 15%.

So our strong recommendation is to take action now as refinancing non-arms length loans can take some months to finalise.

The ATO has indicated it may allocate additional resources to review an LRBA of an SMSF for the 2015-16 years or later years.

Any SMSF with a non-arms length LRBA should seek professional advice immediately.

Happy Investing.