28/02/2018

Would a SMSF trustee decision not to adopt the safe harbour terms from the ATO's Guidelines in relation to a related party loan breach the Superannuation Industry (Supervision) Act SIS (Act)?

The ATO’s Practical Compliance Guidelines PCG 2016/5 (“Guidelines”) provide safe harbour terms which, if complied with, mean the related party loan will be treated as commercial by the ATO and accordingly the trustees can be assured the ATO will not apply the non-arms’ length provisions of the Income Tax Assessment Act to the arrangement.

In April 2016, the ATO assistant Commissioner stressed the fact that adoption of the safe harbour terms was not compulsory, they were simply a safety net for trustees. As far as we are aware, the ATO’s position on this issue remains unchanged (see PCG 2016/5 frequently asked questions page on the ATO website).

If a trustee opts not to follow the Guidelines, they must be ready to demonstrate the loan was entered into and maintained on terms consistent with an arms’ length dealing and present documentary evidence.  

Surprisingly, we have recently been made aware by one of our clients that an auditor listed the failure to follow the Guidelines as a breach of s109 of the SIS Act in their contravention report.  

So what should an SMSF trustee do in this situation?

Firstly, an auditor should notify the trustee as soon as they detect a contravention so the trustee may respond to the issue and, if possible, rectify or have a plan in place to rectify the contravention before the auditor finalises the audit.  

This means the trustee can ask the auditor their reasons for noting the issue as a breach and attempt to change their mind. Is the auditor following some internal auditing rules or policy that all related party loans must abide by the Guidelines? Is the auditor reading too much into the Guidelines? Do they simply (mistakenly) believe adoption of the Guidelines to be mandatory?

Secondly, the trustee may decide to wait and see what action the ATO takes (if any). While an auditor is required to report ‘contraventions’ which meet the reporting criteria set out by the ATO, it is ultimately the ATO who decides whether any further action is required. If the auditor reports the failure of the trustee to follow the Guidelines as a breach of s109 and the ATO’s view is that this position does not in and of itself automatically mean the arrangement is deemed not to be commercial, it is possible the ATO will determine that no contravention has, in fact, occurred.

A word of caution though, it is still possible for the ATO to deem the arrangement not to be at arms’ length if the trustee is unable to demonstrate the loan was otherwise entered into and maintained on commercial terms.

If the auditor stands by their assessment, the trustee may decide to vary the terms of the loan to mirror the Guidelines (and make all relevant catch up payments if the variation is to take effect from the start of the financial year or start of the loan for instance) so the breach is noted as ‘rectified’ on the report.  

This option would only be available where the asset which is subject to the limited recourse borrowing arrangement falls within the two categories of assets the Guidelines apply to (i.e. real property and stock exchange listed shares or units). The trustee should first check with the auditor the proposed course of action would satisfy them the breach has been remedied. Once this has been confirmed, the variation of the loan agreement must be carefully documented and will generally be effected on a retrospective basis.  Trustees should speak to their adviser before proceeding.

Another option is for the trustee to terminate the auditor’s engagement before they issue their report, however this is not the best solution for two reasons.

Auditors still have to report breaches and lodge their Auditor Contravention Report (‘ACR’) with the ATO even if they are no longer the auditor for the fund.  

The auditor will notify the ATO via their ACR that the trustee cancelled the audit, which is likely to be frowned upon by the ATO and result in further investigation.  The trustee is free to use the services of another auditor for the following year’s audit.

How do trustees avoid this heartache?

They can follow the Guidelines (if applicable) from the start of the arrangement.

They may obtain a loan offer to the SMSF from a bank or other commercial lender in relation to the particular asset and benchmark the terms of the related party loan to the loan offer.  The loan offer should be safely kept on the Fund register so it can be readily produced to the ATO or auditor as evidence if requested.

If a trustee is thinking of entering into a related party loan and is still unsure whether the proposed terms would be commercial, they may apply for a private binding ruling to the ATO.  A private binding ruling is an advice from the ATO that outlines how a tax law (in this instance the non-arms’ length income rules) applies to an SMSF in its particular circumstances. Once issued, the ruling is binding on the ATO. The downside of this is if the trustee chooses not to rely on the private binding ruling and ends up breaching the rules, they will be required to pay any underpaid tax (and interest) as well as a penalty.

If you require any assistance with varying the terms of your related party loan or applying to the ATO for a private binding ruling, please contact Townsends Business & Corporate Lawyers on (02) 8296 6222.