Related party LRBAs – choosing the interest rate

31 Jul 2023
Lyn Formica

Lyn Formica

Head of Education & Content

My client’s SMSF purchased a property via an LRBA in March 2023 by borrowing from a related party. When they took out the loan, they adopted the “safe harbour rules” to determine the terms & conditions of the loan. What interest rate should the related party be charging the fund?

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When an SMSF buys an asset under a limited recourse borrowing arrangement (LRBA), the income generated by the asset may be taxed as non-arm's length income (NALI) (ie at 45%) if the terms of the loan arrangement aren’t consistent with an arm's length dealing.

One of the ways to ensure the terms of the arrangement are consistent with an arm’s length dealing is to structure the loan in accordance with the “safe habour rules” of PCG 2016/5. These “safe harbour rules” dictate the terms of the loan arrangement including:

  • the interest rate to be charged,
  • the term of the loan,
  • the loan to market value ratio,
  • the nature and frequency of repayments,
  • the security to be taken, and
  • the documentation required.

In terms of the interest rate to be charged, for real property, the rate for a particular financial year is the Reserve Bank of Australia (RBA) Indicator Lending Rates for banks providing standard variable housing loans for investors for the May prior to the start of the relevant financial year.

So, for example, in the case of a loan commenced in March 2023, the initial interest rate would have been 5.35%, being the RBA rate for May 2022. The trustees could have chosen to fix this rate in place for a maximum of 5 years. If the rate was not fixed (ie it is a variable loan), to comply with the “safe harbour rules”, the rate needs to be reviewed at the start of each financial year and adjusted where necessary. Based on the May 2023 RBA rate, the variable interest rate to be charged for the period 1 July 2023 to 30 June 2024 is 8.85%.

We’ve recently seen loan documentation which requires the interest rate to be reviewed annually on the anniversary of the loan commencing, rather than each 1 July. So, in the case of our example, the 8.85% rate wouldn’t commence until March 2024 (ie 12 months from the loan’s commencement in March 2023). However, we are concerned that loan terms structured in this way do not match the strict requirements of PCG 2016/5.

Note, if an SMSF has entered into an arrangement which does not meet all of the “safe harbour” terms set out in PCG 2016/5, while the trustees are unable to be assured the ATO will accept the arrangement is consistent with an arm's length dealing, it doesn’t mean the arrangement is deemed not to be on arm's length terms. It merely means that there is no certainty provided under PCG 2016/5. The trustees need to be able to otherwise demonstrate that the arrangement was entered into and maintained on terms consistent with an arm's length dealing. One way of doing that is to maintain evidence showing their particular arrangement was established and maintained on terms that replicate the terms of a third party loan offered to the fund in the same circumstances.

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