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SMSFs and Tax traps: How to get limited recourse borrowing right

It’s not often that you get given a glimpse into the mind of the Australian Taxation Office, especially about issues as complex and topical as SMSF limited recourse borrowing.

Limited recourse borrowing is a process by which a self-managed superannuation fund (SMSF) can borrow money to purchase an asset. Super funds are otherwise prohibited from borrowing money, and the tax consequences of getting the transaction wrong can be severe. How severe? Currently 47% tax on the income derived from the transaction.

So a speech given by ATO Assistant Deputy Commissioner of Superannuation Stuart Forsyth on 11 September 2014 is of great interest. In the speech, Mr Forsyth said:

There are some in the SMSF industry who advocate entering into a limited recourse borrowing arrangement (LRBA) with a related party under non-commercial terms. We assume that the purpose is to shift wealth into an SMSF and to minimise, and in some instances possibly avoid, tax…

“… In April, we released an edited version of a private binding ruling request. Based on the facts provided, we stated that income derived by the fund from this nil-interest rate loan arrangement gave rise to non-arm’s length income. The application of this decision is that the non-arm’s length income derived from this arrangement would be taxed at 45% (47% while the temporary budget repair measure is in place).

“In the case in question, a super fund proposed to borrow from a related party. The directors of the corporate trustee were the only members of the fund and the fund was in pension mode. The loan agreement proposed to apply a nil-interest rate. The loan was to be repaid in a single lump sum at the end of the term of the loan. No end term or date was mentioned in the loan agreement. The related party proposed to lend 100% of the value of the assets to be acquired. The asset to be acquired (in this case listed shares) would be held via a custodial trust.

“The elements that led us to conclude that the parties would not be dealing at arm’s length (amounting to a ‘scheme’) in this arrangement were:

      • the lender is not compensated for the opportunity cost in lending
      • there are no regular periodic repayments – only a single lump sum repayment at the end of the loan term
      • 100% of the value of the assets to be acquired will be lent
      • no insistence by the lender on personal guarantees from members of the fund
      • absence of mechanisms for the lender to protect the underlying value of the asset.

“We also concluded that the income that would be derived by the fund would be greater than the amount the fund might have been expected to derive if the parties were dealing with each other at arm’s length.”

“While this private ruling should not be seen as prohibiting LRBAs between related parties, what is clear is that dealings between a fund and a related party must be seen to be at arm’s length. A non-interest loan on its own won’t be enough to taint the income of the fund as being non-arm’s length if it’s derived from a related party investment through an LRBA, but it is a considerable factor. Coupled with other factors such as a high loan value ratio, we’re likely to apply considerable scrutiny to the arrangement.

Mr Forsyth’s comments are a useful reminder that the ATO pays particular attention to the dealings of SMSFs, and that SMSF trustees must think and act carefully when it comes to borrowing.

FWO routinely practices in the area of SMSF law and limited recourse borrowing. If you have any questions in that regard please contact John Watson on 6650 7017. If you have questions in relation to loans or borrowing generally, please contact Jay Clowes on 6650 7016

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