Certain loan arrangements give rise to non-arm's length income
Under the fact scenarios in each of ATO interpretative decisions ATO ID 2014/40 and ATO ID 2014/39 (the Decisions), the Commissioner of Taxation (Commissioner) considered:
- the fund's trustee had acquired a fixed entitlement to the income of the custody trust (Holding Trust) through a scheme, being a compliant limited recourse borrowing arrangement (LRBA);
- looking at the arrangements holistically, the parties to the scheme were not dealing with each other at arm's length; and
- the income that would be expected if the parties were dealing with each other at arm's length would be nil as an arm's length lender would not make such a loan and without the loan, no investment would be made in the relevant asset.
Consequently, all of the income derived from the relevant asset acquired under each LRBA was considered non-arm's length income. Notably, non-arm's length income is taxable at the top marginal rate, currently 47%, regardless of whether the fund is paying a pension.
What facts did the Commissioner consider?
In each of the Decisions, the relevant facts included:
- a loan interest rate of 0%;
- a mortgage granted in favour of the lender;
- no personal guarantees or other security given to the lender;
- a substantial loan term of either 15 or 20 years; and
- a compliant LRBA involving a custody trust (the Holding Trust) in which a custodian held the legal title to the relevant investment, but the SMSF trustee held a beneficial entitlement to the assets of the Holding Trust, including the income arising from the investment.
ATO ID 2014/39 — Investment in listed shares
In ATO ID 2014/39, which considered a borrowing arrangement used to acquire shares in ASX listed companies, the following additional facts were relevant:
- the total amount borrowed was several million dollars for all of the parcels of shares;
- the loans amounted to 100% of the value of the assets acquired under the arrangement (namely a 100% LVR);
- the trustees were only required to repay each loan as a single lump sum at the end of the term, or earlier if agreed with the lender; and
- the fund's trustee company was both the borrower, in its capacity as the fund's trustee, and the lender, in its capacity as trustee of a family trust.
ATO ID 2014/40 — Investment in commercial real property
In contrast, in ATO ID 2014/40:
- the amount borrowed was 80% of the purchase price of the asset (80% LVR);
- the trustees were required to make monthly repayments of principal so that the principal was fully repaid at the end of the 15-year loan term; and
- the fund's trustee company was the borrower, while the fund's members in their personal capacity were the lenders.
What does this mean for related party limited recourse borrowing arrangements?
The Decisions deal with 2 sets of facts which both involved interest free loans. However, both Decisions also involved other circumstances which contributed to the Commissioner determining, holistically, that the parties were not dealing with each other on an arm's length basis.
It is not clear whether the Commissioner would ever accept an interest free loan as being made on arm's length terms, nor the weight that the Commissioner will apply to each of the factors that comprise a borrowing arrangement, such as loan term, guarantees and repayment schedules.
Until such time as the ATO publishes guidance as to the factors the Commissioner will consider relevant when assessing whether an LRBA is entered on arm's length terms, fund trustees and members should consider the following and seek advice as needs be:
- exercise caution to ensure all the terms of the loan can be justified as being commercial;
- seek out evidence of commercial terms — perhaps by obtaining a contemporaneous quote from a commercial lender outlining the terms they would be prepared to lend on;
- where a fund's trustee has an existing related party LRBA clients with interest-free or low rate loans — or other loan terms that may not be commercial — consider varying the loan agreement to reduce the risk of a non-arm's length income assessment for future years.
Is the Commissioner's view correct?
We do not think so.
In each of the Decisions, the Commissioner has adjudged that the correct comparison for the purposes of determining the amount of non-arm's length income, is between:
- the income the fund derives from the Holding Trust — under the actual arrangement; and
- the income the fund might have expected to receive had the parties been dealing at arm's length (Alternative Hypothesis).
The Commissioner's Alternative Hypothesis is that in the factual circumstances set out in the Decisions, the arrangement would never have been entered into. That is, the lender would never have made the loan, the property would not have been purchased and the fund would not have received income from the Holding Trust.
The Commissioner relies on a 2011 Full Federal Court decision (Allen's Case) as authority for this proposition. However, Allen's Case was a case where special income was originally sourced from a distribution from a related discretionary trust. In such a case, the Court found that what 'might have been expected to apply' if the parties had been dealing at arm's length, is that no distribution would have been made to the superannuation fund. It is difficult to see such an approach being taken in these instances, as what 'might have been expected to apply' if the parties had been dealing at arm's length is that the terms of the arrangement would have been varied to reflect arm's length terms.
Arguably, if the parties were dealing at arm's length, then the interest rate and/or the security terms would have been varied. Importantly, however, the transaction would have proceeded otherwise unaltered. Having said that, it needs to be noted that what 'might have been expected to apply' depends on the individual circumstances of each proposed transaction.
If our submission in response to the Alternative Hypothesis is correct, then the non-arm's length income would be no greater than the actual arrangement. This is because:
- if you accept that in either case the property would have been purchased, and the fund would have a fixed entitlement to income under the Holding Trust;
- then under both scenarios, the income received from the Holding Trust will be the same.
But what about the additional interest expense? Remember that the interest expense is met from the SMSF, not the Holding Trust. Therefore, the income received from the Holding Trust (for example, rent received from a tenant) is a gross income amount, regardless of the interest expenses — which are met by the SMSF not the Holding Trust.
Are the Decisions binding?
No. The Decisions are edited and summarised records of ATO decisions only and do not have the force of law.
However, if a taxpayer does not follow an interpretative decision and the decision ultimately proves to be correct, then this could have implications for culpability penalties.
Where can I read the full Decisions
You can access each of the Rulings at:
More information from Maddocks
For more information, contact Maddocks on (03) 9258 3555 and ask to speak to a member of the Commercial team.
More Cleardocs information on related topics
You can read earlier ClearLaw articles on a wide range of SMSF topics.
Order Cleardocs related document packages
- Set up an SMSF
- SMSF set up + register corporate trustee
- Update an SMSF deed
- Set up an SMSF pension
- Create an SMSF Investment Strategy
- Arrange SMSF borrowing documents
- SMSF Death Benefit Nomination — binding or non binding
- SMSF Death Benefit Agreement — binding and permanent
- SMSF Minutes & Resolutions Package
Allen v Federal Commissioner of Taxation(2011) 195 FCR 416.