SMSF related party LRBAs

by | Jun 27, 2016

ATO extends cut-off date to comply with voluntary safe harbour rules to 31 January 2017 but how reliable is PCG 2016/5 anyway?

A chronology of events so far

On 6 April 2016, the ATO released Practical Compliance Guideline 2016/5(PCG 2016/5), which outlined terms on which self-managed superannuation funds (SMSFs) may structure their related party limited recourse borrowing arrangements (LRBAs) to avoid the risk of having a non-arm’s length income (NALI) rate of tax (47%) being applied to the income derived from the leveraged asset(s). SMSFs had until 30 June 2016 to comply with the safe harbour rules for their related party LRBAs to avoid the possibility of an income tax review for the 2014-15 income years and prior.

On 30 May 2016, the ATO announced that the deadline had been pushed back 7 months until 31 January 2017 due to a number of requests from practitioners asking for further time to review their clients’ LRBAs. The ATO went on to state that it will provide a number of practical examples demonstrating how it will apply the NALI rules by 30 September 2016.
On 17 June 2016, the ATO advised that the safe harbour related party LRBA interest rates for the 2016-17 income year were:

  • 5.65% for LRBAs used to acquire real property; and7.65% for LRBAs used to acquire listed securities.
  • By 30 September 2016, the ATO will provide a number of practical examples demonstrating how it will apply the NALI rules.
  • 31 January 2017 – New deadline for putting related party LRBAs on ATO sanctioned terms to avoid the possibility of a NALI rate of tax being applied to income form the leveraged assets.

PCG 2016/5 in brief

For those not aware, PCG 2016/5 perhaps represents a positive step forward by ATO administrators, allowing tax agents and their clients an opportunity to sleep easily at night in regards to SMSFs with related party loans. PCG 2016/5 sets out voluntary terms which, if followed, are accepted by the ATO as being consistent with an arm’s length dealing. This means that the normal 15% “low tax component” rate of tax will apply to income derived from the asset if in accumulation phase (or 0% if in pension phase) rather than the potential 47% NALI rate. It should be reiterated that the guidelines published in PCG 2016/5 are not mandatory. However, SMSF trustees with related party LRBAs that are not structured in accordance with the practical compliance guide will need to demonstrate how their related party LRBAs are on arm’s length terms.
For those that have not already decided to meet the guidelines, it would be prudent to wait until the release of the practical examples (due by 30 September) before deciding what to do.

How reliable is the practical compliance guideline?

PCG 2016/5 represents one of the first ATO pronouncements in the form of a practical compliance guideline. Although they are not public rulings (which provide protection from underpaid tax, penalties and interest), the Commissioner states the following within paragraph 26 of Practical Compliance Guideline 2016/1 (Practical Compliance Guidelines: purpose, nature and role in ATO’s public advice and guidance) which was released on 3 June 2016:

“26. If a practical compliance guideline outlines an approach (for example, an administrative safe harbour) that has clear consequences for determining tax liabilities of taxpayers who rely on that approach in good faith, and the ATO subsequently changes its view and/or the practical compliance guideline is withdrawn or altered, the principles under PS LA 2011/27[4] will be relevant and the ATO will not take action to apply any changed view of the law to prior years. In these circumstances, any action in terms of applying the ATO view of the law will only occur on a prospective basis.”

Based on these comments, taxpayers should be covered retrospectively in the event the guideline is updated or withdrawn. Moreover, the ATO would be unwise to renege on the parameters presented in PCG 2016/5 to arrangements struck on the terms endorsed in that guideline as it would undermine its very purpose and set a dangerous precedent for any other practical compliance guidelines.

An alternative view

The more sceptical observer would see shades of Practice Statement Law Administration 2010/4 (PSLA 2010/4) where to avoid the possibility of unpaid present entitlements to corporate beneficiaries being treated as loans for Division 7A purposes, many taxpayers have committed to binding loan agreements just in case the ATO’s view of the law is correct.

Although PSLA 2010/4 is questionable in its legislative basis, PCG 2016/5 provides taxpayers with a comfort zone in a grey area of the law. This shift to providing a set of parameters/safe harbours which taxpayers can voluntarily meet to avoid the ATO’s scrutiny allows the ATO to better utilise its resources, allowing it to focus on the taxpayers who have chosen to operate outside the guidelines. Logically, taxpayers who do not comply would be at an increased risk of an investigation/audit. With the prospect of further PCGs to come (8 have been released thus far), it will be interesting to note just how many taxpayers voluntarily comply. If the rate is high, will we see this approach being rolled out to a number of other areas?

Conclusion

Nervous Nellies will no doubt welcome the ATO’s black and white guidelines and use them as a basis for their related party LRBAs.

However, SMSFs and their advisers shouldn’t blindly follow the guidelines. If dissatisfied with the ATO’s specified interest rates, maximum loan terms, maximum loan to valuation ratio, etc. they would be well advised to seek out and document the loan terms offered by independent third parties and use these terms as a basis for their related party LRBAs. This would, as it always has been, a solid basis to document the arm’s length nature of their related party borrowings.

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