Limited recourse borrowing arrangements: SMSFs watch out! ATO changes its view on non-arm’s length income

Interest-free or low rate loans to self-managed superannuation fund (SMSFs) from related parties have been the flavour of the month since the ATO’s comments in the National Tax Liaison Group meeting of December 2012. However, the ATO has now decided that the non-arm’s length income rules do apply in a number of recent private rulings, including two we obtained for clients (authorisation numbers 1012585947911, 1012595001544 and 1012582301006).

This means where an SMSF has received an interest-free or low rate loan from a related party, all the income from the LRBA will be non-arm’s length income and taxed at 45%. This penalty tax rate applies even if the SMSF is in pension phase.

The ATO’s primary reason in the rulings we have received is that the SMSF would not have entered into the LRBA if they had to pay commercial interest. As a result, the SMSF would not have received any income from the LRBA in an arm’s length arrangement.

Based on the ATO’s current view, no SMSF should enter into an interest-free or low rate loan without first obtaining a private ruling.

If you have clients with interest-free or low rate loans to their SMSF, you should consider the following:

• Whether you should be reporting the income from the LRBA as non-arm’s length income to avoid interest and penalties.
• Varying the terms of the loan agreement to require arm’s length interest is paid. You must ensure that this variation is properly documented and the new interest rate is supported by extrinsic evidence to show that it is commercial/arm’s length considering the other terms of the loan otherwise the client may breach section 109 of the SIS Act.

You should also consider reviewing all SMSFs with related party loans to ensure that the terms of those loans are consistent with an arm’s length arrangement. For example, if the interest rate is lower than would be expected from an arm’s length lender (having regard to the loan-to-value ratio and repayment terms), the ATO may apply the non-arm’s length income rules.

If you would like to discuss this further, please contact our SMSF Specialist Advisors, Scott Hay-Bartlem, Clinton Jackson or Alex Clifton-Jones