ATO ‘clarifies’ views on SMSF borrowing (LRBA) and non-arm’s length income, but does it change the rules?

In April 2016 the ATO released PCG 2016/5, which outlined its views on when loan terms would result in income from a related party loan for an LRBA being non-arm’s-length income (NALI) to the SMSF (and taxed at top tax rates in the SMSF, rather than the concessional tax rates that usually apply to SMSFs). It included the safe harbour rules for the loan terms.

In September 2016 the ATO released TD 2016/16. This replaces the ATO’s comments in ATO IDs 2015/27 and 2015/28. While it appears that TD 2016/16 is intended to provide more clarification on its views about when the NALI rules will apply to a related party LRBA, its wording does give rise to concerns.

The ATO now argues that if the SMSF could not or would not have entered into LRBA but for the related party loan on non-arm’s length terms, all of the income from the asset bought will be NALI to the SMSF. This is an objective test and the determination sets out a number of factors that the ATO will consider.

The ATO accepts that when the SMSF can objectively establish that it could have and would have entered into the LRBA on arm’s length terms, then a comparison can be made between the actual income from the arrangement and the income that the trustee would have hypothetically received had it entered into an LRBA with borrowings on arm’s-length terms.

This means that where it can be established the LRBA is sustainable on normal commercial terms, the ATO now accepts the income received by the SMSF from the LRBA will not be NALI, even though the related party loan is on non-arm’s length terms favourable to the SMSF. An example is where a related party loan is being used to refinance an existing arm’s length loan.

However, TD 2016/16 provides concerns as it suggests that unless the SMSF can establish it could or would have entered into the LRBA with an arm’s length lender, the income from the LRBA must all be NALI. While the ATO has published the safe harbour rules in PCG 2016/5, the ATO explicitly states in PCG 2016/5 it will apply TD 2016/16 in private rulings and litigation. This means the requirement to prove the ability to enter into an arm’s length arrangement can be seen as an additional requirement, and there is a risk the ATO may argue that merely relying on compliance with the safe harbour rules may not be enough.

As a result of TD 2016/16, it is essential that care is taken when setting up a LRBA with a related party loan or implementing or refinancing a related party loan. If the loan terms do not comply with the safe harbour guidelines in PCG 2016/5 and the SMSF does not have evidence to show the availability of funds from an arm’s length lender, clients should consider obtaining a private ruling to ensure that the NALI provisions do not apply.