A SMSF broadly has two means of funding the purchase of income-producing investments – one from member contributions and, if certain conditions are met, from borrowings.
The Superannuation Industry (Supervision) Act 1993 (“SIS Act”) contains stringent rules on what assets can or cannot be acquired and how loans are to be structured to ensure that borrowing arrangements (particularly where the lender is a related party) are SIS Act compliant.
Increasingly, SMSF members are willing to lend to their SMSF, either in their individual capacity or through their non-SMSF companies or trusts that they control or influence (i.e. a “related party”). Quite often, there has been interest (no pun intended) in providing these loans at low or nil interest rates.
SMSF members also need to be aware of the potential tax consequences to their SMSF of borrowing from related parties or where the parties are not dealing at arm’s length. Specifically, where income derived from an investment (that was acquired from related party loans) is classified as non-arm’s length income for tax purposes, SMSFs are not taxed on that income at the usual concessional rate of 15%, but rather at the highest marginal tax rate of 45%.
What is non-arm’s length income?
Section 295-550 of the Income Tax Assessment Act 1997 (ITAA 1997) provides that an amount of income derived by a SMSF is “non-arm’s length income” if:
- it is derived from a scheme the parties to which were not dealing with each other at arm's length in relation to the scheme; and
- that amount is more than the amount that the entity might have been expected to derive if those parties had been dealing with each other at arm's length in relation to the scheme.
So, consider the situation where a SMSF member, through his family trust, intends to lend money (at a low interest rate) to the SMSF so that the SMSF can purchase an income-producing asset.
In such a situation, it is likely that the income is being derived from an asset that was acquired under a “scheme” whereby the family trust lender and the SMSF borrower are not dealing with each other at arm’s length.
It would be natural to assume that where a related party provides a loan at low or no-interest rate terms that the interest rate ‘differential’ between the discounted (or nil) interest rate and a commercially set rate would be deemed ‘non-arm’s length income under section 295-550 of the ITAA 1997. However, it appears that this is not the case.
What has the ATO said recently?
The ATO has indicated its view in the Minutes of the December 2012 NTLG Meeting (Section 6.1) that a low-interest loan does not give rise to non-arm’s length income.
The ATO has also indicated that a low-interest loan also does not in itself contravene section 67A of the SIS Act and section 109 of the SIS Act, the latter point being consistent with ATO ID 2010/162.
This ATO view appears to be supported by two recent private binding rulings (Authorisation Number: 1012396819768 and Authorisation Number: 1012414213139), which appears to indicate that no-interest loans would not give rise to non-arm’s length income.
However, the ATO seems to have done a ‘back-flip’ in its most recent private ruling (Authorisation Number: 1012582301006). The ATO ruled (among answering other questions) that income derived by the ‘Custody Fund’ (it being a portfolio of ASX listed shares) that was acquired from an effectively no-interest related party loan would be considered arm’s length income.
On the face of it, this private ruling does not sit well with the ATO’s view from its two previous private rulings and from its view expressed in the December 2012 Minutes of the NTLG Meeting that a low interest loan would not give rise to non-arm’s length income.
However, a deeper review of the three private rulings reveals that the ATO’s decisions in those ruling were not solely determined on the fact that the loan charges low or no-interest.
What’s the ATO really looking for?
Taxation Ruling TR2006/7 outlines the Commissioner’s view on what constitutes “special income” (the predecessor to “non-arm’s length income”) from related party transactions. Whilst the question “does a low or no-interest related party loan give rise to non-arm’s length income?” is not answered, the Taxation Ruling does highlight that the Commissioner will consider all relevant factors to answer that question. Importantly, the level of investment risk that the SMSF is being exposed will be a relevant factor in that determination.
Following TR2006/7, and at the risk of oversimplifying the facts and circumstances of each private ruling, it appears that the factors that the ATO has considered in these three private rulings to determine if whether a related party loan would lead to the derivation of non-arm’s length income under section 295-550 of the ITAA 1997 include:
- whether a loan is low or nil interest does not necessarily by that fact alone give rise to non-arm’s length income;
- whether the income derived from the income-generating asset purchased from the loan is at arm’s length;
- whether the purchase price of the proposed investment is arrived at from arm’s length dealing with an unrelated vendor;
- the nature of the investment being purchased from the borrowings;
- the amount of the loan as a percentage of the value of the investment (the LVR ratio);
- whether the income derived from the investment itself (rather than on a net basis) was increased due to the non-arm’s length nature of the loan arrangement.
Effectively speaking, for a related party loan to pass the ATO’s ‘smell’ test, the totality of the loan arrangement and the asset being acquired needs to be considered. Whether a loan is provided on a low or no-interest rate basis is only one factor that the ATO takes into account.
TR2006/7 also highlights the point that though the SMSF borrower and the lender may be related parties, so long as you are dealing at arm’s length, non-arm’s length income would not arise.
It is more often than not that where a loan has been offered at a low or no-interest rate terms, it is an indication that the parties are not dealing at arm’s length.
It is always worth bearing in mind when making a loan to your SMSF that as a first step, you need to consider whether the investment being purchased with your loan is the right investment for your SMSF, having regard to the SMSF’s investment strategy and your own personal circumstances.
Appropriate documentation regarding the terms of the loan, how the borrowing is structured, and that the SMSF had paid due consideration to the transaction as a whole is paramount to ensuring that not only is the borrowing SIS Act compliant, but that income does not become ‘non-arm’s length income’ as a result of the related party borrowing to ensure that the 15% tax rate concession continues to be enjoyed by the SMSF.