All limited recourse borrowing arrangements (LRBA) involving related-party loans should be reviewed prior to Christmas to ensure they do not generate non-arm’s-length income.
To ensure this is the case, the trustee must either:
• confirm the loan agreement satisfies the safe harbor terms set out in Practical Compliance Guideline PCG 2016/5 (in which case the ATO will accept the arrangement is an arm’s-length dealing), or
• be able to demonstrate the terms of the loan are consistent with an arm’s-length dealing despite the fact the terms do not satisfy all of the guidelines (if a trustee proposes to adopt this approach, it is important to fully document the basis for doing so).
The review should be conducted before the Christmas break because if issues are detected, the trustee will need time in January to engage lawyers to fix the problem by 31 January 2017.
Where the terms of a loan are not consistent with an arm’s-length dealing and are not corrected before this date, a breach of section 109 of the Superannuation Industry (Supervision) Act is likely to end up in an auditor contravention report for your fund.
What characteristics should you be looking for when considering if the loan arrangement is not at arm’s length and not within the guidelines?
Interest rate
The guidelines state that for LRBAs used to acquire property an acceptable variable interest rate is the Reserve Bank of Australia indicator lending rate for banks providing standard variable housing loans for investors, which for 2015/16 was 5.75 per cent and currently sits at 5.5 per cent. For loans acquiring shares it is an additional 2 per cent on top of the interest rate for property. Existing loans with nil interest or fixed rates exceeding five years for property or three years for shares will certainly need to be examined.
Term of the loan
Lengthy loan terms may be a problem as they give the trustee greater time to repay, thereby increasing the balance in their SMSF, which over time may accrue additional earnings. When reviewing the loan agreement, you need to ask is the term longer than 15 years for property or seven years for shares?
Loan-to-value ratio
The loan-to-value ratio (LVR) is generally what the banks would assess to determine what they would lend you for the purchase, that is, ‘that much’ for ‘that property’. The nature of the limited recourse transaction is that the bank can only go after the asset purchased with the loan and cannot go after the other assets of the SMSF if the value of the property drops below the loan value. So it’s unsurprising many banks sit around a 70 per cent to 80 per cent LVR when lending to SMSFs.
The guidelines say the LVR for the initial loan (or refinance) shouldn’t exceed 70 per cent for property or 50 per cent for shares. Loans made over this LVR may have been used for SMSFs with low balances that could not afford to pay a full deposit.
If the value of the LRBA asset has dropped and the LVR is higher than the maximum permitted, it is important to consider paying down some of the loan prior to refinancing to ensure the LVR doesn’t exceed the maximum thresholds.
Mortgage
Has a mortgage been registered as security for the related-party loan? Some trustees may have opted not to register a mortgage if they were the lender in their personal capacity. The risk of defaulting appears to be low, but the ATO has clearly stated a registered mortgage over the property is required to ensure the transaction is at arm’s length.
Frequency and type of repayments
How often are the repayments and what type of repayments are they? The guidelines state repayments should be monthly and include principal and interest (that is, no interest-only repayments). If only interest has been paid on the loan, you will need to ensure both principal and interest repayments are made for the period commencing from 1 July 2015.
Documentation
A written (signed and dated) loan agreement is important in meeting the guidelines to demonstrate the loan terms to your auditor and the ATO.
Important note
The ATO has stated the guidelines are indicative rather than prescriptive. Trustees are not obligated to follow the guidelines if they can show evidence that supports the LRBA was conducted as an arm’s-length transaction.
Tax Determination 2016/16 may be a useful guide in assessing whether the evidence the trustee holds is sufficient.
It is important to understand there may be liability on professional advisers who do not take proactive steps to ensure their clients’ LRBAs meet the requirements by the 31 January 2017 deadline.