Following consultation with the industry, the ATO has recently issued two interpretative decisions (ID), ATO ID 2014/39 and ATO ID 2014/40, clarifying its position on zero interest loans issued to SMSFs by related parties.
Concerns over zero interest rate related-party loans have gradually increased since the ATO early last year issued private rulings stating such arrangements could result in non-arm’s-length income (NALI), currently taxed at 47 per cent.
The ATO’s view rests broadly on the premise the income derived from the arrangement is considered to be greater than what would have been derived had the parties been dealing with each other at arm’s length, triggering the NALI provisions in the Income Tax Assessment Act.
With respect to ATO ID 2014/39, the ATO adversely noted:
- The lender was not by way of charging interest or by any other means compensated for the opportunity cost in lending or for the additional risk of the borrower’s default under a loan given the limited recourse nature of the loans and lack of other security,
- Rather than regular periodic repayments of the principal amount there is only a single lump repayment at the end of a loan term.
100 per cent of the value of the assets to be acquired is lent, rather than a lower loan-to-value ratio (LVR). - The lender has not sought personal guarantees from the members.
With respect to ATO ID 2014/40, the ATO adversely noted:
- The members provided information that the standard loan terms a third-party financier or bank would offer an SMSF entering into a limited recourse borrowing arrangement to acquire real property would involve an LVR of between 60 per cent and 70 per cent. The members also stated although the LVR in this case is 80 per cent, the scheme did not require or provide for any such additional security nor were there additional terms or obligations to help mitigate the risk associated with an LVR that is higher than 60 per cent to 70 per cent.
- The interest rate is 0 per cent and there is no other means by which the lenders are compensated for the loss of the ability to use their capital, which is due to be returned to them through equal monthly repayments over 15 years.
Following the release of the IDs, the ATO issued further guidance on the application of the NALI provisions. Factors the ATO is likely to consider include the:
- nature of the acquirable asset,
- amount borrowed,
- term of the loan,
- LVR,
- interest rate charged, or the other means by which the lender is compensated for the opportunity cost in lending the principal,
- regularity and frequency of principal repayments,
- security taken, such as mortgages and personal guarantees,
- extent to which the loan has operated in accordance with its terms, and
- evidence that establishes that the terms and conditions and ongoing operation of the loan are consistent with what an arm’s-length lender dealing at arm’s length would accept.
The ATO says the matters listed above when taken together need to be consistent with what an arm’s-length lender would accept in relation to the borrowing.
Points to note
It has long been recognised asset allocation, not security selection, is the key driver of long-term investment results. One of the most powerful insights of modern portfolio theory is the finding that allocating capital across risky assets can actually reduce overall portfolio risk, due to the benefits of diversification.
Unless related-party loans measure up to arm’s-length terms and conditions, the income derived by the SMSF is likely to be taxed as NALI unless the fund has previously obtained a favourable private binding ruling.
Therefore, SMSFs that have related-party borrowings should ensure they retain benchmark evidence to support their arm’s-length terms and conditions or otherwise implement changes to this effect to limit the risk of a NALI tax assessment.