LRBAs: can you drown in the safe harbour?

For some time, there has been speculation and uncertainty regarding related party limited recourse borrowing arrangements (LRBAs) entered into by self managed superannuation funds (SMSFs). In particular, it has been unclear in what circumstances these loans will engage the non-arm’s length income (NALI) provisions in section 295-550 of the Income Tax Assessment Act 1997 (Cth). If these provisions apply to any income derived from an arrangement, tax at the highest marginal rate will be payable on that income (even if the SMSF is in pension mode).

On 6 April 2016, the ATO released Practical Compliance Guideline 2016/5 (PCG), which was intended to reduce this uncertainty by setting out ‘safe harbour’ loan terms on which related party LRBAs might be structured so as to be considered consistent with arm’s length dealings (and therefore not to trigger the NALI provisions).

The ATO has announced in the PCG that it will not be taking compliance action against SMSFs that have LRBAs on terms that are not consistent with arm’s length dealing, if those terms are amended appropriately by 30 June 2016, or the LRBA is terminated by 30 June 2016. In each case, payments of principal and interest must be made on appropriate terms for the year.

The ‘safe harbour’ terms apply to loans used to acquire real property, listed shares and listed units.

They cover interest rates, whether rates may be variable or fixed, the loan term, the loan to market value ratio (LVR), security, personal guarantees, the nature and frequency of payments and the nature of the loan agreement.

Now that the dust has settled somewhat, and practitioners are reviewing their clients’ LRBAs in light of the PCG, what queries are arising?

What is a PCG, and what certainty does it provide?

The ATO started to issue Practical Compliance Guidelines earlier this year, subsequent to the issue of PCG 2016/D1, which explains their nature and purpose. In brief, while these Guidelines give some indication of the ATO’s views on how the tax laws apply in relation to certain schemes, their primary function is to ‘enable taxpayers to position themselves within a range of behaviours, activities or transaction structures that the ATO describes as low risk and unlikely to require scrutiny – to safely ‘swim between the flags’’ (see paragraph 5).

A PCG therefore lacks the legally binding effect of a Public Ruling. However, the ATO explains the comfort these Guidelines provide to taxpayers as follows:

25. If a Guideline outlines an approach (for example, an administrative safe harbour) that has clear consequences for determining tax liabilities of taxpayers who rely on that approach in good faith, and the ATO subsequently changes its view and/or the Guideline is withdrawn or altered, the principles under PS LA 2011/27 will be relevant and the ATO will not take action to apply any changed view of the law to prior years. In these circumstances, any action in terms of applying the ATO view of the law will only occur on a prospective basis. (see paragraph 25, PCG 2016/D1)

SMSFs that have an LRBA can therefore proceed on the basis that, if their LRBA is structured in accordance with the ‘safe harbour’ rules in PCG 2016/5, the Commissioner will accept that it is consistent with an arm’s length dealing and the NALI provisions will not apply by reason only of its terms (see paragraph 2 of PCG 2016/5).

What are the limitations with the PCG?

‘Safe harbours’ may not be all that safe

It is easy to focus on safe harbour rules in any context and to overlook other issues that fall beyond their scope. As regards the PCG, it must be remembered that this applies only to the specific matters that it covers. NALI could still arise as an issue even if the terms of the LRBA itself fit neatly within the safe harbour rules. For example, other features of the arrangements (such as the mortgage terms, or the basis on which the asset was acquired) could be quite uncommercial, and this could attract the NALI provisions.

The ‘safe harbour rules’ are very specific – what if my client’s LRBA looks a bit different?

If the terms of a related party LRBA fall outside the ‘safe harbour’ rules, this does not necessarily mean they will attract the application of the NALI provisions, or the attention of the ATO. It simply means that the SMSF does not have the benefit of the comfort offered by PCG 2016/5. The existing position applies – that is, it is up to the SMSF trustee to be ready to demonstrate the ‘commerciality’ of the loan, such as by holding evidence that it is on terms consistent with the terms of commercially available facilities.

What if my client has used an LRBA to acquire investments other than real property or listed shares/units?

The PCG only applies to real property, shares in listed companies and units in listed unit trusts, and the ‘safe harbour’ rules are therefore not available to SMSFs that have used an LRBA for other purposes, such as to invest in unlisted companies or unlisted unit trusts, including companies and trusts under Regulation 13.22C of the Superannuation Industry (Supervision) Regulations 1994. These SMSFs will therefore need to hold evidence showing that the terms of their LRBAs are consistent with commercially available terms.

While the release of the PCG does not change this long-standing position, it may cause advisers to give the gathering of this evidence greater attention, as it seems clear that the ATO expects SMSFs to have identified commercial loans available in the same circumstances, and to have benchmarked the terms of the related party loan against them. This may create a practical challenge for some SMSFs, where the nature of the asset acquired falls outside the institutions’ accepted lending criteria.

How should I calculate the loan to value ratio?

One of the practical issues with the PCG is that it requires loans to have a LVR not exceeding 70% for real property and 50% for listed shares/units. The PCG does not explain how this ratio is calculated and, in particular, whether the expenses associated with the acquisition of the asset (such as fees, GST and stamp duty) should be excluded from the value of the property. Pending any further guidance on this point from the ATO, the safest course would seem to be not to deduct such expenses when determining the value of the property for these purposes.

The bottom line

From 1 July 2016, the ATO expects that that all related party LRBAs will be on commercial terms, and it seems clear that it will be allocating more resources to the application of the NALI provisions to those that are not.

Before 1 July 2016 advisors should take the following actions:

  • Review their clients’ LRBAs where there are related party loans, and check the terms against the safe harbour rules.
  • Where an LRBA relates to real property or to listed shares or units, ensure that action is taken before 30 June 2016 where necessary to:
    • amend the terms of such loans, so as to bring these within the safe harbour rules, and ensure that payments of principal and interest on the amended basis are made for the year (or form a view as to whether any deviations are of such significance as to require attention); or
    • refinance through a non-related lender (i.e. on actual arm’s length terms); or
    • pay out the loan (and ensure that payments of principal and interest are made for the year on terms consistent with an arm’s length dealing).
  • Where an LRBA relates to any other asset, consider whether the trustee of the SMSF is in a position to demonstrate that the terms are consistent with commercially available terms.

 Get in touch with us

Please contact us if you’d like to discuss how the PCG may affect you or your clients, or require assistance with re-documenting, refinancing or terminating a related party loan.


Andrew O’Bryan

Andrew specialises in taxation law. He is a CPA Australia Fellow and Chairman of its Taxation Centre of Excellence.

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