The New Danger for SMSFs with Zero Interest Related Party Loans
28/04/2014
A number of recent private binding rulings released by the ATO concern limited recourse borrowing arrangements (LRBA) related party loans and appear to have foreshadowed dire tax implications for such arrangements which may be found to have uncommercial loan terms.
Of most concern is the ATO’s warning that income generated from a LRBA may be considered as non-arm’s length income if the terms of the loan result in a greater amount of returns to the SMSF than what might otherwise be expected if it was dealing with a lender at arm’s length.
The tax implications
By deeming the income from such arrangements to be special income, a significant tax rate of 45% would be applied to all rental income, dividends, interest and capital gains/losses derived from the asset.
Accordingly, this has the potential to result in a significant tax bill for the SMSF and potentially calls into question whether the trustees have acted in the best interest of the members by entering into such a loan agreement.
So what terms do we need to watch out for?
The ATO has highlighted the following features of related party loans which may result in the application of special income taxation to the LRBA, including but not limited to:
- uncommercial loan to value ratio
- unsecured loans
- zero or below-market interest rates
- unspecified or particularly lengthy loan periods.
In particular, loans with these terms which are made for the acquisition of shares or units by an SMSF increase the likelihood of the income being found to be non-arm’s length income, as the ATO considers that commercial lenders are even less likely to lend on such terms given the limited tangible security which can be provided.
However, the ATO has indicated that it takes a holistic view of the loan arrangement and the use of one (or possibly more) of these terms in conjunction with other commercial terms (eg. nil interest rate, but with a more commercial LVR and loan period) may not necessarily result in the SMSF having to pay special income taxation on the derived income. However what combination of these terms would be approved by the ATO seems to only be determined on a case by case basis at the moment and no further guidance has been provided.
What to take away from this?
The ATO’s expanded view in this area reflects well on the advice we have given to clients all along – it would be prudent to make sure any related party loans are on commercial terms.
We often suggest that for clients mimicking commercial lender terms that they keep documentation (eg. Lender’s brochure, website print out, loan offers) demonstrating these terms, to provide to an auditor or the ATO in the future.
For those who have current related party loans in place and are concerned with the derived income being determined as non-arm’s length income, it may be wise to review the current loan terms and consider whether these should be varied to ensure they are indeed at arm’s length and commercial.
Such a variation must be properly documented by the parties, keeping in mind that it should not give rise to a new borrowing arrangement. With the increased penalty regime of the ATO starting on 1 July 2014 it would be appropriate to review these loans before the starting date as the ability of the ATO to impose a fine will apply to existing non-compliance after that date.
If you would like our firm to review current loan terms or assist you with preparation of loan variation documents please contact us on (02) 8296 6222.