Q: My wife and I have an SMSF which purchased a federal government tenanted commercial property in December 2015 using a bank supplied limited recourse borrowing arrangement (LRBA).
This was a comparably expensive financing solution so we recently borrowed funds outside of our SMSF using property owned by our family trust. We then lent this new bank loan to our SMSF to pay out the bank LRBA.
The interest rate dropped from 5.7 per cent variable to 2.09 per cent principal and interest fixed for four years, a major cost saving. We now have an LRBA between my SMSF and my family trust.
I would like to know what rate of interest my family trust should be charging my SMSF for this financing facility. As the new loan is exclusive to our LRBA arrangement, can we simply “label” it as our SMSF loan and treat it as such. That is, avoid the need for charging interest and account fees between the entities. Simon
A: Where a self-managed super fund switches a property loan from a bank to a related-party financier, which is what your family trust appears to have done, it’s not as simple as mirroring the debt arrangement you have with your bank with the arrangement your family trust must have with your fund.
There are many issues you need to consider, says SMSF auditor Belinda Aisbett, a director of Melbourne-based Super Sphere.
As the regulator of SMSFs, the Australian Taxation Office is very clear about the requirements that need to be met when a related party lends money to refinance your property loan.
It insists this must take place on arm’s length terms where what your fund has negotiated to refinance the loan is on the same or similar terms as what an independent lender would have done.
This includes that the borrowing arrangement places no other assets of the SMSF at risk should there be any problems meeting mortgage repayments.
Failure to ensure this can result in some major compliance issues with the structure of the debt.
For example, under superannuation guidelines described as the “safe harbour” provisions, the interest needs to be at an ATO approved rate – for the 2021 and 2022 financial years, this rate is 5.1 per cent per annum. So you cannot simply charge the 2.09 per cent interest rate. You would have to charge 5.1 per cent.
A standard bank loan is generally priced much differently to a limited recourse loan against an SMSF. This is because the mortgage and security obtained under an LRBA reflect much greater risk.
Interest can be fixed, Aisbett says, but only for a maximum of five years. After this, you will need to switch to a variable interest rate. In addition, the maximum loan term must be for 15 years.
The loan to value ratio – the proportion of the value of a property in comparison to the amount of money being borrowed – must be 70 per cent or less when the loan is made.
With regard to your specific question, you cannot simply label the new loan as the SMSF loan, says Aisbett. You will need formal documentation that provides evidence of this loan between your family trust and your SMSF.
A mortgage must be taken out and registered over the property by the related-party financier – your family trust.
There must also be a written loan agreement that spells out the limited recourse nature of the loan – where only the property asset is vulnerable should a loan default occur – and the other standard loan terms.
Repayments on the loan must, for instance, be monthly and include an interest and capital component.
These are specific rules set out in an ATO practical compliance guideline (PCG 2016/5) that you can refer to if you want more information. Known as safe harbour provisions, they are described as arm’s length terms for LRBAs established by self-managed superannuation funds.
What’s important about the provisions is that if the fund is in the safe harbour, the rent on the property can be taxed as ordinary income. Where the fund is in the accumulation phase the tax rate will be 15 per cent. In the pension phase the income may be tax-exempt.
If it is outside the harbour, the property’s rent – less relevant expenses – would need to be taxed at 45 per cent, regardless of whether the fund has pension or accumulation members.
According to Aisbett, where a fund has an LRBA an auditor must, as part of the annual audit, check the fund has complied with the safe harbour provisions.
That’s because the auditor needs to ensure the fund’s tax obligation has been correctly calculated.
That said, as much as the arm’s length requirements are set by the ATO, it’s a financial audit issue not a compliance audit issue that would require it to be reported as a potential contravention under the SMSF compliance breach requirements.
Where an SMSF auditor believes there could be a problem, Aisbett says that she would explain the safe harbour criteria and why the fund falls outside them.
She would advise the fund, including the fund accountant or administrator, that the tax needs to be recalculated. This advice could be given without the auditor necessarily viewing the fund’s financial accounts as it is unlikely a fund would present its financials to the auditor volunteering non-arm’s-length income.
When dealing with an LRBA, it is important to understand the consequences that may arise where it is not implemented and maintained on a proper basis.
This is especially so in the case of an SMSF undertaking a related-party LRBA, says Daniel Butler of DBA Lawyers.
It’s the ATO’s view, he says, that if a property arrangement does not comply with the safe harbour criteria, the asset is generally tainted for the rest of its life. This means that any capital gain on a future disposal is liable to being taxed as non-arm’s-length income. Therefore, in addition to a 45 per cent tax on ongoing net rental income from the property, 45 per cent tax would also apply on any net capital gain earned on the future sale or disposal of the property, after any applicable CGT discount is applied. An SMSF is entitled to a one-third CGT discount on an asset held for more than 12 months.