The ATO has provided clarification concerning an SMSF that entered into a limited recourse borrowing arrangement (LRBA) prior to 31 January 2017 and the application of the 1 July 2018 non-arm’s length expenditure (NALE) legislative amendments. The clarification has removed a conflict between PCG 2016/5 and LCR 2021/2.
A little background to the conflict
After the SIS Act was amended to allow an SMSF to borrow to acquire an asset under an LRBA, questions arose in relation to setting the terms of a related party loan, under an LRBA, and whether certain terms may cause a superannuation compliance issue. Essentially, the focus was on the interest rate of the related party loan and when the rate was less than a market value rate, including a zero interest rate. The ATO considered this issue in respect of a number of aspects of the superannuation law, including:
- ATO ID 2010/162 – Whether an SMSF contravenes the arm’s length dealing rule in section 109 of the SIS Act, where the terms of the related party loan are more favourable to the SMSF, e.g., less than a market rate interest rate. The ATO’s view was that whilst the terms cannot be more favourable to the related party than would have been the case had the parties been dealing at arm’s length, there is no contravention of the arm’s length rule in section 109 of the SIS Act if the terms are more favourable to the SMSF.
- National Tax Liaison Group (NTLG) Superannuation Technical Sub-group June 2012 meeting, which considered the following issues:
- Whether a discounted or zero interest rate would be considered a contribution – ATO’s response was no, as the absence of a requirement to pay interest does not increase the capital of the fund;
- Whether a related party loan under an LRBA with a zero interest rate, but with repayments of principal, would be considered a loan – ATO’s response was yes, it would still be considered a loan.
These views from the ATO appeared to give the green light to using related party loans, under an LRBA, that have very favourable terms to the SMSF. For example, a zero interest rate and a 100% loan to value ratio. However, the income tax implications of such arrangements, particular the non-arm’s length income (NALI) provisions, were generally not considered. Generally, this was due to the NALI provisions at the time only focusing on gross income, before the 1 July 2018 amendments to include the concept of non-arm’s length expenditure (NALE).
The ATO issued two Interpretative Decisions, ATO ID 2015/27 (listed shares) and ATO ID 2015/28 (real property) that considered the application of the NALI provisions in the Tax Act to an LRBA where the related party loan was not on arm’s length terms. Both of these IDs concluded that the NALI provisions, as they then existed, would treat the income from such LRBA arrangements as NALI.
These two IDs were effectively replaced by a Taxation Determination, TD 2016/6 which dealt with the same issues. The TD also concluded that where the terms of the borrowing arrangement, the scheme, was not on arm’s length terms, the ordinary and statutory income from the scheme would be caught under the NALI provisions. Again, this is the NALI provisions that existed at the time, prior to the 1 July 2018 amendments.
Opportunity to rectify
The ATO issued Practical Compliance Guidelines (PCG) 2016/5 which provided an opportunity for an SMSF with an LRBA that was not on arm’s length terms a period to address them. Where the terms of the LRBA were updated in accordance with the PCG the ATO would not select the SMSF for an income tax review for the 2014-15 or earlier income years purely because the SMSF entered into an LRBA. The period to address a non-arm’s length LRBA ended on 31 January 2017 and the PCG provided affected SMSFs with three options:
- Alter the terms of the related party loan to meet the guidelines in the PCG; or
- Refinance the related party loan with a commercial lender; or
- Pay out the LRBA.
By applying one of the three options by no later than 31 January 2017, the ordinary and statutory income from the LRBA would not be at risk of being treated as NALI, or so it was thought.
The 1 July 2018 NALE amendments & LCR 2021/2
Despite the ATO’s view, in TD 2016/6, that an LRBA that was not on arm’s length terms would be caught under the NALI provisions, amendments were made to the NALI provisions in the Tax Act to introduce the concept of non-arm’s length expenditure (NALE), which would give rise to a superannuation fund having NALI. One of the purposes of the amendments was to clarify any ambiguity in the application of the law that existed prior to the amendments. For example, paragraph 2.20 to the Explanatory Memorandum (EM) to the Bill that introduced the amendments said:
“Similarly, the application of paragraphs 295-550(1)(b) and 295 550(5)(b) may be ambiguous where expenses incurred by a superannuation entity in respect of an asset are not on arm’s length terms, but the amount of ordinary income or statutory income from the scheme is the same as might be expected had the dealing been at arm’s length. This may be the case, for example, where real property is acquired under a limited recourse borrowing arrangement and where the rent derived under the scheme is at market rates but the interest paid on the loan is not.”
So, this would make it clear that the ordinary or statutory income from an LRBA that was not on arm’s length terms would be caught by the NALI provisions, even where, for example, the asset under the LRBA was acquired at market value and the income derived was arm’s length. Reference can also be made to examples 4 and 12 in LCR 2021/2.
Whilst PCG 2016/5 provided an SMSF with a non-arm’s length LRBA options to avoid being subject to the NALI provisions, the 1 July 2018 NALE legislative amendments have the potential to nullify the PCG with ordinary and statutory income derived from the LRBA being subject to the NALI provisions.
The Fabulous Super Fund, an SMSF, acquired a residential property from an unrelated vendor for $365,000 via an LRBA in 2014. The LRBA involved a related party loan that was not on arm’s length terms, that is, the interest rate was 2% and the LVR was 90%.
The SMSF utilises PCG 2016/5 and applies the first option to alter the terms of the related party loan to meet the safe harbour guidelines by 31 January 2017. The SMSF continues to hold the property under the LRBA, however, the terms of the loan meet the ongoing safe harbour guidelines, including relevant adjustments to the safe harbour interest rate.
As the SMSF has taken action to ensure the LRBA terms comply with the safe harbour guidelines by 31 January 2017, it should be confident that the ordinary and statutory income derived from the LRBA will not be subject to the NALI provisions in the Tax Act.
However, whilst the NALE amendments only apply in relation to income derived in the 2018-19 and later income years, well after the LRBA in our above example has been altered to meet the safe harbour guidelines, they apply to any scheme (LRBA), even where it was entered into prior to 1 July 202204 2018¹. Consequently, the ordinary and statutory income derived from the LRBA from the 2018-19 income year could be subject to the NALI provisions. In our above example, that would be the net rental income and any capital gain from the disposal of the property.
Whilst the LRBA in our example was altered to comply with PCG 2016/7 using option 1, it did not matter which of the three options were utilised, the LRBA and the asset held under it, are potentially forever tainted from a NALI perspective. Basically, it’s unfixable.
Here in lies the conflict. The SMSF has complied with the ATO guidance so the NALI provisions that existed at the time were not applied. However, a subsequent legislative amendment has the potential to pull it back into the scope of the NALI provisions.
The ATO updated PCG 2016/5 on 21 March 2022 to insert a new paragraph (17A) to reflect an extension (to later income years) of the Commissioner’s compliance approach to the application of the NALI provisions to LRBAs entered into prior to the 2014-15 income year and that were made consistent with an arm’s length dealing by 31 January 2017, in compliance with PCG 2016/5.
The new inserted paragraph states:
“An SMSF trustee who satisfies the condition set out in paragraph 16(i) of this Guideline with respect to an LRBA can also be assured that the Commissioner will not apply compliance resources to determine whether paragraphs 295-550(1)(b) or (c), or paragraphs 295-550(5)(b) or (c), of the ITAA 1997 apply to income derived by the SMSF for the 2018-19 and later income years from an asset that is subject to that LRBA.”
The insertion of paragraph 17A to PCG 2016/5 provides comfort to the trustee of the Fabulous Super Fund that the ordinary and statutory income derived from the LRBA in the 2018-19 and following income years will not be subject to the NALI provisions simply because the LRBA was not on arm’s length terms when it was entered in to².
1. Paragraph 3 of LCR 2021/2.
2. Subject to continuing compliance with PCG 2016/5.
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