On 28 September 2016, the ATO released a Practical Compliance Guideline (PCG 2016/5) and a Taxation Determination (TD 2016/16), regarding limited recourse borrowing arrangements and ‘arm’s length terms’.
The ATO has revised its previous position and clarified the circumstances, and the extent to which, a SMSF may be exposed to non-arm’s length income tax assessments when they enter into these borrowing arrangements.
The ATO’s revised approach represents a more balanced approach regarding these issues.
There was a fundamental problem with the ATO’s previous approach to evaluating whether a SMSF’s LRBA exposed the fund to an assessment for non-arm’s length income (assessed at the highest marginal rate).
Previously, the ATO said it would look at the terms of the related party loan. They said that if an arm’s length lender would not make a loan on those terms, then all ordinary and statutory income from the LRBA would amount to NALI.
Our position was always that the ATO, in looking at the terms of the related party loan, should not just substitute the related party with a bank, and determine whether the bank would make that loan: rather, the ATO should assess how the terms of the related party loan would be different if the lender was a bank (or arm’s length lender).
That is now the position the ATO has adopted, with some conditions imposed along the way.
What is the ATO’s revised position?
The relevant ATO publications
The release of the Practical Compliance Guideline (PCG 2016/5) and the Taxation Determination (TD 2016/16) have altered the way the ATO will treat limited recourse borrowing arrangements (LRBAs) with related party lenders, for the purposes of determining exposure to the non-arm’s length income (NALI) provisions in section 295-550 of ITAA 1997 (Act).
When will the ATO treat dealings as being on arm’s length terms?
The ATO will only treat dealings as being on arm’s length terms if the arrangements reflect what might be expected to have occurred if the parties to the scheme had been dealing with each other at arm’s length. For example:
- PCG 2016/5 still contains safe-harbour terms for related party loans, which if reflected in the relevant transaction documents, will ensure the NALI provisions do not apply
- the parties must otherwise determine what terms would have been offered to the SMSF trustee by an unrelated third party lender.
So apart from the safe-harbour provisions, how will the ATO assess whether the arrangement is on arm’s length terms?
When assessing whether an arrangement is on arm’s length terms, the ATO will assess whether the SMSF has derived more ordinary and statutory income under the scheme then it might have been expected to derive if the parties had been dealing with each other at arm’s length regarding the scheme.
In order to determine what the parties might have been expected to derive had the parties been dealing with each other at arm’s length (hypothetical situation), one must identify:
- the steps of the relevant scheme
- the parties to the scheme
- the amount of ordinary or statutory income that the SMSF might have been expected to derive if the same parties to the scheme had been dealing with each other on an arm’s length basis
- the terms of the borrowing arrangement under the hypothetical arrangement, such as:
- the interest rate
- whether the interest rate is fixed or variable
- the term of the loan
- the loan to market value ratio.
Once the hypothetical situation has been determined, it is necessary to consider whether the SMSF would have or could have entered in to the hypothetical borrowing arrangement. This is a very important assessment and bears out the key difference from the ATO’s previous position (as explained further below):
- If the SMSF could not have or would not have entered in to the hypothetical arrangement, then ALL the ordinary or statutory income from the related party arrangement will be taken into account in assessing the SMSF’s exposure to a NALI assessment
- If the SMSF could have and would have entered into the hypothetical arrangement, then the NALI provisions may apply to the assessment of tax on the SMSF’s taxable income, but only to the extent that taxable income is more than it would have been under the hypothetical situation.
Factors the ATO considers concerning whether the SMSF ‘could have’ include:
- whether the SMSF’s deed imposes any impediments and allows the borrowing arrangement
- whether the SMSF has sufficient capital available
- the ability of the SMSF to service the arm’s length terms
- any legislative or regulatory impediments which might prevent the SMSF from acquiring the asset.
Factors the ATO considers concerning whether the SMSF ‘would have’ include:
- whether the borrowing arrangement was consistent with the SMSF’s investment strategy
- whether the borrowing arrangement was the optimal use of the SMSF’s funds
- whether the borrowing arrangement, taking into account future income and capital gains, would be earnings accretive.
How does the ATO’s revised position differ from its previous position?
The ATO’s previous position can be summarised as follows:
- The ATO’s approach – of comparing the actual terms to hypothetical arm’s length terms – was largely the same as set out above.
- The ATO asked, in respect of the non-arm’s length parties, ‘have the parties, in respect of [the] dealing, dealt with each other as arm’s length parties would do, so that the outcome of their dealing is a matter of real bargaining’.1
- The key difference with the ATO’s previous position, was that in answering that question, the ATO’s position was that:
It might be expected that an arm’s length lender would not lend any capital on the loan terms that form part of the scheme. Without that loan it might be expected that there would be no investment in the asset through the Holding Trust and so no ordinary or statutory income might be expected to be derived by the Fund from the asset.
- In contrast to its current position, the ATO’s previous position was that it would not entertain an argument that the loan between the related parties would still have gone ahead, albeit on different terms, stating in the same ID that:
It is no answer to this conclusion to say that the Fund could have obtained a loan from an arm’s length lender on different terms or that the Fund could have used other means by which to acquire the asset, as that is not the scheme into which the parties have entered.
- You will see from the above that:
- the ATO’s revised position is to review the terms of the scheme between the non-arm’s length parties and identify what the terms would have been in the hypothetical borrowing arrangement
- whereas the ATO’s previous position was to substitute the related party lender with an arm’s length lender, apply the exact same loan terms, and decide whether or not the arm’s length lender would make the loan.
- The implication of this was that, if the ATO took the view that an arm’s length lender would not have provided the loan on the agreed terms, then all income from a non-arm’s length LRBA was exposed to an assessment for NALI.
- The position is now very much in contrast: if one can demonstrate that the SMSF would have and could have entered into a hypothetical LRBA, then the exposure to a NALI assessment is limited to the additional income which the SMSF derives from the actual related party LRBA compared with the hypothetical LRBA.