With the release of ATO interpretive decisions ID2014/39 and ID2014/40, the regulator has clearly indicated its assessing action in respect of non-commercial limited recourse borrowing arrangements (LRBA).
SMSF advisers must now consider the following four issues regarding the subject: firstly, whether a particular LRBA is on non-commercial terms; secondly, what the tax and regulatory consequences are of a borrowing being on non-commercial terms; thirdly, whether the ATO reasoning is open to attack; and finally, what actions can now be taken to minimise any adverse assessing action.
Whether a particular LRBA is on non-commercial terms
The ATO has not clearly identified the metes and bounds as to when a particular LRBA will be non-commercial. The arrangements that are the subject of the two IDs are clearly at the extreme: for ID 2014/39 the relevant parameters were the zero interest rate and 100 per cent loan-to-value ratio (LVR), while for ID 2014/40 the relevant parameters were the zero interest rate and 80 per cent LVR.
The tax office has provided no ‘safe harbour’ and each SMSF adviser must reach their own conclusion. However, the ATO has advised that if the terms of the LRBA are materially comparable to the terms offered by unrelated lenders (this is called benchmarking), then the arrangement will not be non-commercial.
It seems the three critical elements are the interest rate, repayment terms and the LVR. One high-street lender is currently offering a 5.04 per cent interest rate (three-year fixed) with a maximum LVR of 80 per cent. It can be argued an interest rate of not less than 5 per cent is a commercial rate. Equally, LVRs of not exceeding 80 per cent will be commercial. The repayment terms of principal and interest would also be commercial – possibly not necessarily monthly, but at least half-yearly repayments.
Consequently, any current LRBA that has an interest rate of less than 5 per cent or has an LVR of greater than 80 per cent and has no regular repayments is highly likely to be treated by the ATO as being a non-commercial LRBA.
In particular, there is no need to match the division 7A of the Income Tax Assessment Act 1936 (ITAA 1936) interest rate (unless driven by division 7A issues) or the fringe benefits tax interest rate, which are currently 5.95 per cent and 5.65 per cent respectively. These interest rates have been set for particular purposes and are not intended to be current market rates.
The tax and regulatory consequences of non-commercial LRBAs
If a particular LRBA arrangement is non-commercial, then the net proceeds of the arrangement (net lease payments and disposal proceeds) will be taxed at 47 per cent. This taxation treatment applies even if the fund is a complying fund in pension phase.
Simply having a non-commercial LRBA does not cause the fund to thereby be non-complying. A non-commercial LRBA (where the non-commerciality favours the fund) is not a breach of section 109 of the Superannuation Industry (Supervision) (SIS) Act. Also, a non-commercial LRBA is not a contravention of section 67 of the SIS Act (assuming the arrangement otherwise satisfies the requirements of section 67A). A non-commercial LRBA (where the non-commerciality favours the fund) will not breach the sole purpose test of section 62 of the SIS Act. Finally, simply because the LRBA is non-commercial does not mean there has been a contravention of a prescribed operating standard of SIS regulation 4.09 (investment strategy covenant). It may be that entering into an arrangement that subjects a fund to the penalty tax rate of 47 per cent may breach the statutory covenants applying to the fund by reason of section 52B of the SIS Act (due care and diligence, best interests), but this is a matter between the trustee and the members (or beneficiaries) and does not involve the ATO or the regulatory status of the fund.
ATO decision reasoning
The ATO has heavily relied upon the decision in the Allen’s Asphalt case. There a substantial capital gain of $2 million was derived in a hybrid trust. The capital gain was allocated to a beneficiary in its capacity as trustee of a fixed trust, which in turn was allocated to the beneficiary of the fixed trust in its capacity as trustee of the Allen’s Asphalt Staff Superannuation Fund, an SMSF (despite its name), the members of which were the principals of the hybrid trust.
As the relevant transactions in the Allen’s case occurred during the 2003 financial year, the relevant legislation was section 273 of the ITAA 1936, which dealt with special income of a complying superannuation fund. The current provision, being section 295-550 of the ITAA 1997, applies from 1 July 2007 and is materially similar to the former section 273. The current provision has adopted the term ‘non-arm’s-length income’ in lieu of ‘special income’. Additionally the current provision has removed any doubt that it applies to both ‘ordinary income’ and ‘statutory income’. This amendment undermined the main argument raised by the taxpayer in the Allen’s case.
The significance of the Allen’s case is the court had to consider the application of section 273 as it applied to the income of the particular SMSF being income derived from a fixed entitlement. Sub-section (7) of section 273 is materially equivalent to section 295-550(5). In particular, both provisions specify if the income derived from the fixed entitlement is greater than the income which might have been expected to be derived if the parties were dealing with each other at arm’s length, then the derived income is non-arm’s-length income.
In the circumstances of the Allen’s case, the ATO successfully argued that if the parties had been dealing with each other at arm’s length, no distribution would have been made. Consequently, the entire amount of the distribution was therefore special income.
The ATO has applied similar reasoning in the two interpretative decisions: if the parties to the loan transaction were dealing with each other at arm’s length, no loan would have been made. Further, if there was no loan, there would have been no acquisition of the property. Consequently, the entire income derived from the property is non-arm’s-length income and therefore to be taxed at 47 per cent.
Is the ATO reasoning in the two interpretative decisions like Caesar’s wife, beyond reproach? There seem to be three responses.
The first is the ‘complete denial’ defence of Basil Fawlty and that is to deny the terms are not arm’s length.
The second is to argue that the subsection focuses on the income derived from the fixed entitlement.
And, the third is to argue the hypothetical alternative is not ‘no transaction’, but a transaction on different terms.
Basil Fawlty defence
This would make interesting court entertainment. Unfortunately, it would be a difficult task to argue that a no interest loan is arm’s length. Possibly it is a honeymoon interest rate and the ATO has simply walked in during the honeymoon.
Income is in fact arm’s length – ATO is looking at the wrong item
A better argument is the income to which the provision refers can only be the income paid by the tenant of the property. If the tenant is an unrelated party, then the income is derived from a scheme in relation to the parties who are dealing with each other at arm’s length. If so, paragraph (a) is not satisfied and so section 295-550(7) therefore cannot apply. The ATO may counter by responding the scheme is not a leasing arrangement between the custodian and the tenant; the scheme extends to the loan terms and the SMSF and the lender are not dealing with each other at arm’s length. The counter-response is that paragraph (b) is not satisfied because the income is, in fact, not greater than would be derived if all the parties to the scheme were dealing with each other on an arm’s-length basis. The income referred to is the income from the tenant, which is market rate.
This counter-response rests upon the fact that income is a gross item and not a net item. Given a low or zero rate of interest payable on the loan, the amount of income has not thereby increased, merely that there is reduced or no interest expense.
Straw man hypothetical
The third argument (and probably the best) is that the ATO has adopted a straw man hypothetical as the relevant yardstick or comparison position. The straw man for the ATO is that there would have been no loan and therefore all the income derived from the asset (lease and possibly capital proceeds on disposal) is non-arm’s-length income. This is not the only alternative hypothetical.
It can be argued a non-arm’s-length lender would have lent at 5 per cent up to 80 per cent of the value of the property based upon current figures. In this case the quantum of the income which should be treated as being non-arm’s-length income is the excess income from the actual position compared to the position where the hypothetical lender loaned the money.
Where the actual and hypothetical comparison positions differ only in the interest rate – then the excess income is the interest differential. For example, if the actual interest rate was 2 per cent on a $500,000 loan and the comparison interest rate was 6 per cent, then the excess income is $20,000.
Where the actual and the hypothetical comparison positions differ in both interest rate and LVR, the same principle could still apply.
Essentially the argument is the income that should be taxed at 47 per cent is the interest saving.
Responses
There are five responses to non-commercial LRBAs, of which four are rational.
The first response is the Basil Fawlty response, which would be entertaining but little else.
The first rational response is to vary the terms of the non-commercial LRBAs to bring them into line with benchmarked commercial terms. Given the offending element of the transaction is the loan agreement, the terms of the agreement can be varied by mutual consent of the lender and the borrower. If the only offending element is the interest rate, this is straightforward to vary. If the offending element is or includes the LVR, then either additional security may have to be provided or the loan principal reduced, either by repayment or by loan forgiveness, to reduce it to an acceptable benchmarked level or both. It should be noted any loan repayment could be financed by the sale of other assets of the fund or by way of recently received contributions. Reduction by way of loan forgiveness will be treated as a contribution to the fund and contribution cap issues will arise.
The second rational response is to dispute the ATO’s determination of the quantum of non-arm’s-length income.
The third rational response is to refinance the existing arrangement with a high-street bank or specialist SMSF lending house. The principal problem will be that the bank or finance house will impose an LVR limit. Consequently the principal will have to be reduced to the acceptable LVR level. The reduction could be by way of loan repayment or loan forgiveness.
The fourth rational response is to close out the current LRBA arrangement by selling the asset to a third party. There are two very significant considerations to this response. Firstly, the particular asset may be a business critical asset. Secondly, the sale could generate an unwelcome capital loss. Finally, the ATO may, consistent with its positions expressed in the two interpretative decisions, take the view the realisation proceeds are also subject to section 295-550 of the ITAA 1997 and should be taxed as special income.