The budget and the ATO safe harbour rules impact on SMSF borrowings – action needed by 30 June

What are the ATO safe harbours?

The ATO recently released Practical Compliance Guidelines PCG 2016/5, which contains two “safe harbours” for related party LRBAs that can assist in ensuring an SMSF is not subject to an assessment for non-arm’s length income (NALI).

Under s 295-550 of the Income Tax Assessment Act 1997 superannuation funds must pay tax at 47% (15/16 financial year) on any income derived from arrangements which are not arms length, as opposed to the usual concessional tax rate on income of 15% (or 0% where income is derived from assets wholly supporting a pension).

Recently the ATO have deemed a number of related party LRBAs to be generating NALI because they have been assessed as not being on commercial arm’s length terms.

Why apply the safe harbour terms to existing related party LRBAs?

The Commissioner states that an SMSF will not be subject to an ATO income tax review (eg an audit) for the 2014/15 or earlier income years on the basis of having entered into an LRBA, if both:

• The LRBA is entered into on terms consistent with the safe harbours by 30 June 2016 or is otherwise brought to an end by that date; and
• Payments of principal and interest for the year ended 30 June 2016 are made under LRBA terms which are consistent with arms length dealing.

The safe harbours are particularly useful for those trustees who are unsure as to whether their related party LRBAs are on arm’s length terms, or whether they have been compliant with arms length terms.

We recommend that the safe harbours be utilised to the fullest extent possible to protect SMSFs.

However if a safe harbour is not satisfied, this doesn’t mean a NALI tax liability will arise. The underlying law has not changed. The safe harbours are merely an additional feature available to protect a SMSF but if a LRBA can otherwise be proven to be arm’s length it should be able to avoid being assessed as generating NALI.

Accordingly, the safe harbours do not have to be utilised despite what some advisors may be indicating. In fact it appears that many arms length LRBAs entered into with commercial lenders have terms which are far more generous than what is being stipulated under the safe harbours and these could be used as benchmarks to demonstrate that comparable related party LRBAs are also arm’s length.

What are the terms required for a LRBA under the safe harbours?

There are two categories of safe harbour rules being for:

1. LRBAs where the asset acquired is real estate (including commercial and residential); and
2. LRBAs where the assets acquired are listed units or shares.

There are no safe harbour rules provided for LRBAs holding other types of assets such as unlisted units so SMSFs will need to be able to separately demonstrate that such LRBAs are on arm’s length terms.

The table below summarises the safe harbour terms required for each of the two stated LRBA categories.

How must the asset being acquired be secured?

The ATO’s guidance states that in order to access a safe harbour, the asset acquired under the LRBA must be secured.

This means that if the asset acquired is real property a mortgage must be executed and registered on title and if the assets acquired are listed units or shares a specific security agreement must be executed and registered on the Personal Property Securities Register (PPSR).

Personal guarantees are not required.

How were the interest rates determined under safe harbour rules?

The interest rates required for a LRBA to access the safe harbours are from the Reserve Bank of Australia Indicator Lending Rates for the month of May immediately prior to the start of the relevant financial year available here.

For real estate, the relevant interest rate is the standard housing loan variable rate for investors. For listed securities the relevant interest rate is the standard housing loan variable rate for investors plus 2% pa.

Compliance with the required LVR ratio

The loan to valuation ratio is the ratio of the amount of the loan to the value of the asset acquired which must not exceed 70% for real property or 50% for listed shares or units.

For example, if the market value of a property is $1 million, then the loaned funds for the LRBA cannot exceed $700,000 under the safe harbour rules. This may mean that a substantial amount of an existing loan will need to be repaid to fall under the safe harbour rules by 30 June 2016.

Impact of reduced concessional and non-concessional contributions caps in the Budget on LRBAs and the safe harbours

Some SMSFs rely heavily on members contributing to their fund to assist in repaying borrowings undertaken through a LRBA.

The Federal Budget introduced measures including:

• A lifetime non-concessional contributions cap of $500,000 which will apply retrospectively to members who have made such contributions since 1 July 2007 (although no penalty will apply where this cap has been breached up until 7.30 pm on 3 May 2016 being Budget night); and
• A reduced concessional contributions cap of $25,000 to apply to all individuals regardless of age from 1 July 2017.

If the existing coalition Government is returned these measures could have a dramatic impact for some funds as many members will have already used up their lifetime non-concessional contributions cap and it may be difficult for some SMSFs to obtain sufficient cash flow to meet their borrowing commitments.

This is very much a ‘watch this space’ situation but it may be that changing a LRBA so that it is on terms that meet the low LVR requirements in the safe harbour rules will assist funds which will be impacted by these changes. However many funds may simply not have sufficient access to cash to pay down their loans adequately.

Additionally, the retrospective application of the lifetime $500,000 non-concessional contributions cap may prevent SMSFs from being able to pay down their loans to fall within the safe harbours in the first place.

Division 7A LRBAs and the safe harbour rules

Generally speaking the safe harbour rules have equivalent or stricter requirements in terms of the required term, security and interest rate payable as compared to the requirements for a Division 7A loan – but this is not always the case.

Some aspects of Division 7A, such as the minimum yearly repayment requirements, are stricter than the safe harbour rules so careful consideration needs to be given to amending Division 7A LRBAs to ensure Division 7A is always complied with, as Division 7A has legislative force.

What do trustees need to do by 30 June 2016?

Any related party LRBAs where trustees do not have documented proof that they have been entered into and maintained on arm’s length commercial terms should be reviewed and, if necessary, trustees should either:

• Attend to amending their arrangements to meet the safe harbours by 30 June to protect them from ATO reviews; or
• Obtain and keep documented evidence demonstrating the arrangement is arms length (such as evidence of comparable terms offered by commercial lenders).

In addition arm’s length commercial payments of interest and principal must be made for the 2015/16 financial year. We can assist in these reviews and in updating the terms of a LRBA to ensure they meet the requirements including preparation and registration of any security documents required.

Trustees may of course take potentially less appealing actions to deal with non arms length LRBAs such as:

• Repaying the borrowings and terminating the LRBA by 30 June 2016; or
• Having a commercial lender refinance the related party LRBA.

In addition, the ATO have indicated that trustees can write to them to seek relief where they are concerned about their ability to make repayments on commercial terms before 30 June 2016.

Trustees needing assistance rearranging their related party LRBAs can contact us on the details below.

This article was written by Robert O’Donohue, Partner and Terence Wong, Solicitor.