Recent rulings from the ATO have created confusing and conflicting positions on zero interest loans for SMSFs, marking a potential end of the arrangements as an effective strategy for acquiring assets under related-party loans. Now, the industry is demanding further clarity on the form of the legislative change, Krystine Lumanta reports.
The rationale behind the Australian Taxation Office’s (ATO) change of heart on zero interest loans has been the topic of heated debate as it’s left a large question mark over the legitimacy, status and specifics of zero and low interest related-party loans taken out through SMSFs.
The ATO originally indicated through Private Binding Rulings (PBR) 1012414213139 and 1012396819768 that it did not acknowledge the discount as a contribution or that it breached the non-arm’s-length income provisions in sections 295 to 550 of the Income Tax Assessment Act (ITAA).
Additional commentary by the ATO to the National Tax Liaison Group (NTLG) superannuation technical meeting in June 2012 expressed the same views and was taken by many in the industry as a green light.
Fast forward to April and the ATO has made a backflip, announcing its intention through PBR 1012582301006 to define the income derived from the assets acquired through these loans as non-arm’s-length.
This latest U-turn means all income from the limited recourse borrowing arrangements with a zero interest loan will now be non-arm’s-length income, giving rise to a 45 per cent tax liability.
With the NTLG no longer in existence, the industry has been left without a forum in which to debate the decision or seek further guidance in terms of what’s acceptable and what’s not.
Wilkinson Superannuation director Mark Wilkinson says he doesn’t agree with the ATO’s conclusion, as it has left SMSF trustees and advisers without any true clarity.
“At the end of the day, they’re a regulator; they should be far more proactive and tell us what their view is,” Wilkinson tells selfmanagedsuper.
“Most people I’ve spoken to believe this latest ruling is flat out wrong.
“But there might be something in the facts that weren’t disclosed that explains it.”
The problem with PBRs
Institute of Chartered Accountants in Australia head of superannuation Liz Westover says while PBRs can be useful in understanding the ATO’s thinking on certain arrangements, the industry has inadvertently used them as a benchmark for all taxpayers.
“A PBR is based on some very specific questions on a very specific scenario,” Westover says.
“The ATO is only responding to the circumstances in this particular case, so there needs to be an element of caution around relying on anything that comes out of a PBR if you’re not the person who applied for it.”
In addition, the industry isn’t provided the specifics of a PBR or accompanying documentation and therefore only received a sanitised version of it, Westover says.
“So while we read this recent ruling, we’re not privy to a lot of the detail and there may be reasons why the ATO has come out with their particular stance in the context of a normal, fairly standard arrangement of zero per cent loans,” she says.
“For example, their definition of non-arm’s-length is: ‘Is the income more than would’ve been expected if they had transacted at arm’s-length?’ so if someone’s saving money on their interest payments, that’s not actually income, that’s a reduction on their liability.
“If you look at that specific loan piece, I would argue that section 295-550(5) of the ITAA doesn’t apply.”
The ATO has been reluctant to reveal its official stance, she says, resulting in advisers having to take a sensible and cautious approach until such time.
“We’re also encouraging the tax office to give certainty to consumers that are looking at these arrangements,” she says.
Wilkinson says the recent ruling was also inconsistent and was not accompanied by any further guidance.
“I think the ATO has always understood what the potential exposure was and they probably were not overly concerned initially because the reality is, in order to really take advantage of it you’ve got to have large amounts of cash in your own name, so there are not actually that many people in a position to take advantage of it,” he says.
“But I know after talking to advisers who have applied for PBRs, they lodged 12 to 18 months ago and didn’t get an answer, so the ATO has sat on them for a while and thought about how to approach it.”
The lack of underlying facts also means advisers are unable to distinguish between the differences between the new and old rulings, he says.
“What’s caused all the kerfuffle is this arm’s-length or special income provision of section 295-550(5) of the ITAA,” he says.
“We have these inconsistent positions that have been adopted by the ATO.
“So what do you tell a client when they see you? Does it all turn on the fact that they’re borrowing 100 per cent or the fact that there’s no security provided? Nobody knows.”
New interpretation leaves grey areas
Townsends Business & Corporate Lawyers principal Peter Townsend says the industry is unable to understand precisely where the line is drawn on what constitutes non-arm’s-length income.
“A nought per cent loan would not necessarily be of itself a non-arm’s-length transaction because, for example, sharia law, as I understand it, does not permit the judging of interest,” Townsend says.
“So on any loan written under sharia law there may be a zero per cent loan, but it would still be arm’s-length.”
In addition, the various aspects of the arrangement’s totality – the percentage of interest, the loan-to-value ratio (LVR), additional security and the repayment period – were in limbo, he says.
“The question is, how many of these things would we need to change before it was tipped back the other way?” he says.
“That’s the argument. But we don’t know the ATO’s position on that scenario and how it balances up in terms of the different areas that may fall outside the non-arm’s-length provision.”
NowInfinity principal Grant Abbott says the exact percentage of acceptable interest is another issue that is up in the air.
“The difficult thing is it’s not just zero per cent,” Abbott says.
“For example, if the market rate is 6.5 per cent and you’re charging 6 per cent, there’s that extra half per cent and because at the moment there’s about a 2 per cent to 3 per cent difference between various market rates, which one is the one you use? If you make a mistake, you’re going to get caught.”
Townsend says he does not expect the ATO to eliminate zero interest loans altogether.
“I think they will maintain their view that all of the indicia have to be considered in order to work it out,” he says.
“If they ban nought per cent, then what would people taking out a sharia loan do? They wouldn’t be allowed and that would be discriminatory, so I don’t believe the ATO will take that attitude, but they’ll sum up all of the circumstances and suggest to people to take great care.
“The way around this, of course, is not to do it. Charge them the commercial rate and provide suitable security, maintain a viable LVR and maintain a sense of proportion when you do these things.”
Wilkinson firmly believes the law will change. “The reason is that it’s completely inequitable,” he says.
“Why should the fact that somebody who has $1 million in their own name be able to get income and capital gains growth completely income tax free because they are already wealthy?
“Effectively what these low interest loans do, while they weren’t intended to do this in the first place, is circumvent the contribution caps.
“If you’re going to have contribution caps, they’ve got to be the same for everybody and while you’ve got the ability for very wealthy people to lend interest free to their super funds, it’s not a level playing field.”
He believes Treasury must look at the current outcomes of the arrangements and determine whether it’s what they originally envisioned for the superannuation environment. “If not, change the law. It’s actually very easy,” he says.
“Potentially, they may allow low interest loans, but limit them to the non-concessional cap, for example. There would at least be a degree of equity with that, in my view.”
Westover agrees a legislative resolution is required. “I don’t think the ATO particularly likes these arrangements, but the fix ultimately will need to be a legislative one because some of the arguments that the ATO has put in this PBR I would question, notwithstanding those arguments are set on a very specific set of circumstances,” she says.
“The upshot is if the government or regulators don’t like these arrangements, then change the legislation to say ‘we don’t think that these are in the spirit of the law or should be occurring’, or it may be simply taking out the second part of section 109, which talks about the favourable terms to the other party.
“Either way, people are looking for some clarity around these arrangements so they can move forward or not.”
The effects of the ATO’s latest interpretation coupled with expectations of a clearer position from the tax body mean the standing of existing loan arrangements falls into question. “Generally when there is legislative change it is prospective not retrospective and we’d certainly encourage that in this case,” Westover says.
“It can be extraordinarily difficult to unwind some of these transactions, particularly when you’re talking about very lumpy, large valuable assets like real estate.
“Ultimately you don’t want [legislators] to unwind them at the detriment of the trustee, so that needs to be appropriately considered.”
She says clarity is paramount going forward. “I don’t think the loans have necessarily been pushed by advisers, but when you layer it in the context of contribution caps, people are looking at ways to maximise their retirement savings and sometimes that means looking at any opportunity, within the bounds of the law, as to how they can increase those savings,” she says.
“We encourage people to do that. We want people to maximise their retirement savings.
“That’s why it’s important to provide that legislative certainty. People want to get on with it and line their ducks up, but knowing they’re within the bounds of the law; that’s certainly where their intention is, but it’s difficult when you’ve got this grey, murky area.”