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My client’s SMSF is intending to enter into an LRBA by borrowing from a related party. How do they decide on the terms and conditions of the loan?
The super law doesn’t dictate any particular terms and conditions for borrowings by super funds, other than requiring that the loan is limited in recourse etc.
However, the super and tax laws do generally require, that SMSFs and their related parties deal with each other on an arm’s length basis (ie on commercial terms). Striking appropriate LRBA terms and conditions is therefore particularly important when the lender is a related party. In contrast, where the SMSF borrows from a bank or other commercial lender, the terms are automatically considered to be arm’s length.
So, how should an SMSF trustee and a related party lender decide on the terms and conditions of a proposed loan?
Fortunately, the ATO has created a list of terms and conditions for superannuation loans that are called “safe harbour” terms (these are set out in Practical Compliance Guideline 2016/5). Funds that adopt these terms can presume that the loan is commercial without having to do any extra work to prove it. The terms and conditions in PCG 2016/5 include:
- benchmark interest rates,
- maximum loan terms,
- maximum loan to market value ratios,
- security requirements,
- nature and frequency of repayments, and
- the existence of a written and executed loan agreement.
Unfortunately, PCG 2016/5 considers only two scenarios for related party loans:
- an SMSF borrowing to buy real property (commercial or residential), and
- an SMSF borrowing to buy listed shares or listed units in a trust.
What if an SMSF wants to borrow from a related party to purchase other types of assets, say units in an unlisted unit trust?
In this case, the onus will be on the SMSF trustee to demonstrate that the related party loan was entered into and maintained on terms consistent with an arm's length dealing. There are a couple of ways of doing that:
- The SMSF trustee could seek finance from a bank or other commercial lender, with the trustee then benchmarking the terms and conditions of the related party loan to an offer made by the financial institution in relation to that particular asset. Note, benchmarking to quotes is unlikely to be enough to establish the commerciality of the loan terms and conditions.
- Alternatively, the SMSF trustee could seek a private ruling from the ATO in relation to whether the proposed loan terms are considered consistent with an arm’s length dealing.
Note, if the SMSF trustee can’t find a commercial lender willing to lend for the particular asset, then it may be difficult to convince the ATO that a related party loan over the same asset is a commercial arrangement.
What are the consequences if the SMSF borrows from a related party and the loan terms and conditions are not considered arm’s length?
The ATO takes the view that if a super fund loan is not on commercial terms and those terms are more favourable to the fund, all the income earned from the asset bought with the borrowed money (including any capital gains) will be classified as “non arm’s length income” or NALI and taxed at 45%.
The SMSF’s auditor may decide to qualify Part A of the fund’s audit report (ie the financial audit) in this situation if this 45% tax rate hasn’t been applied and the differential would have a material impact on the fund’s financial position.
In the unusual situation where the terms of the loan were more favourable to the related party lender (ie the SMSF was worse off by the transaction), the SMSF would breach the super law. In this situation, the auditor may consider qualifying Part B of the fund’s audit report (ie the compliance audit) and lodging an Auditor Contravention Report with the ATO.
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