The release of PCG 2016/5 comes as no surprise, which follows on the back of the Australian Taxation Office (ATO) publications ATO ID 2015/27 and ATO ID 2015/28, which set the tone for related party Limited Recourse Borrowing Arrangements (LRBAs).  The ATO’s 2015 position clarified that nil interest rates and/or interest rate terms being other than “commercial” in nature, constituted “non-arms’ length income” within the meaning of subsection 295.550(1) of the Income Tax Assessment Act 1997 (ITAA97).

PCG 2016/5 sails past interest rates, and now gives the ATO’s position on the entirety of related party LRBAs, including requirements for principal and interest monthly payments, security, terms of lending and standards for setting fixed and variable interest rates.

IS ANYONE REALLY SURPRISED BY PCG 2016/5?

Given the overriding “sole purpose test” at section 62 of the Superannuation Industry (Supervision) Act 1993 (SISA) – what would lead anyone to think a related party LRBA could be made on other than an “arms’ length” basis, with a commercial standard of reference required?  Let’s think this through – we are limited in acquiring assets from members and “related parties” of members by section 66 of the SISA, we are prohibited from providing financial assistance to members and relatives of members by section 65 of the SISA and we are required to deal with investments at an “arms’ length” in accordance with section 109 of the SISA.  So, does it come as any real surprise that, if a member or a related party of the member is going to lend money to the self-managed superannuation fund (SMSF), it has to be on commercial terms?

It scares me when Trustees lose sight of the overriding black cloud of Part IVA of the ITAA97, and forget that the ATO has the benefit of hindsight in assessing anti-avoidance schemes.  Looking beyond Trustees, those of us advising Trustees must also be alert to our civil, and possible criminal, exposure under SISA, including but not limited to section 55 of the SISA, which puts us, as advisors, on the line to pay losses or damages suffered by any “person” (not limited to members) as a consequence of another “person” (not limited to trustees) involved in a contravention of a SISA covenant.   Remembering the Courts and Financial Ombudsman Service quite often favour the consumer, we need only look to section 52 of the SISA to appreciate the broad liability stacked on our shoulders when giving advice to SMSF Trustees of any nature which is other than, on its face, based on all parties acting on commercial arms’ length terms.

Let’s look, therefore, at PCG 2016/5.  Whilst the ATO provides us with peace of mind as to its interpretation of “arms’ length terms” for purposes of related party LRBAs in the Safe Harbour provisions, the ATO recognises at paragraph 4 of PCG 2016/5 that other arrangements may nonetheless be based on arms’ length terms.

Safe Harbour 1:  The LRBA and real property (commercial or residential)

Interest Rate Reserve Bank of Australia Indicator Lending Rates for banks providing standard variable housing loans for investors. Applicable rates:

– For the 2015-16 year, the rate is 5.75%[1]

– For the 2016 17 and later years, the rate published for May (the rate for the month of May immediately prior to the start of the relevant financial year)

Fixed / variable Interest rate may be variable or fixed

–  Variable – uses the applicable rate (as set out above) for each year of the LBRA

–  Fixed – trustees may choose to fix the rate at the commencement of the arrangement for a specified period, up to a maximum of 5 years.

The fixed rate is the rate published for May (the rate for the May before the relevant financial year).

The 2015-16 rate of 5.75% may be used for LRBAs in existence on publication of these guidelines, if the total period for which the interest rate is fixed does not exceed 5 years (see ‘Term of the loan’ below)

Term of the loan Variable interest rate loan (original) – 15 year maximum loan term (for both residential and commercial)

Variable interest rate loan (re-financing) – maximum loan term is 15 years less the duration(s) of any previous loan(s) relating to the asset (for both residential and commercial)

Fixed interest rate loan – a new LRBA commencing after publication of these guidelines may involve a loan with a fixed interest rate set at the beginning of the arrangement. The rate may be fixed for a maximum period of 5 years and must convert to a variable interest rate loan at the end of the nominated period. The total loan term cannot exceed 15 years.

For an LRBA in existence on publication of these guidelines, the trustees may adopt the rate of 5.75% as their fixed rate, provided that the total fixed-rate period does not exceed 5 years. The interest rate must convert to a variable interest rate loan at the end of the nominated period. The total loan cannot exceed 15 years.

Loan to Market Value Ratio (LVR) Maximum 70% LVR for both commercial and residential property

If more than one loan is taken out to acquire (or refinance) the asset, the total amount of all those loans must not exceed 70% LVR.

The market value of the asset is to be established when the loan (original or re-financing) is entered into.

For an LRBA in existence on publication of these guidelines, the trustees may use the market value of the asset at 1 July 2015.

Security A registered mortgage over the property is required
Personal guarantee Not required
Nature and frequency of repayments Each repayment is of both principal and interest

Repayments are monthly

Loan agreement A written and executed loan agreement is required

Safe Harbour 2:  The LRBA and a collection of stock exchange listed shares or units

Interest Rate Reserve Bank of Australia Indicator Lending Rates for banks providing standard variable housing loans for investors plus 2%. Applicable rates:

–  For the 2015-16 year, the interest rate is 5.75% + 2% = 7.75%[2]

–   For the 2016-17 and later years, the rate published for May plus 2% (the rate for the May before the relevant financial year)

Fixed / variable Interest rate may be variable or fixed  – Variable – uses the applicable rate (as set out above) for each year of the LBRA
– Fixed – trustees may choose to fix the rate at the commencement of the arrangement for a specified period, up to a maximum of 3 years (see ‘Term of the loan’ below). The fixed rate is the rate for May plus 2% (the rate for the May before the relevant financial year)

The 2015-16 rate of 7.75% may be used for LRBAs in existence on publication of these guidelines, if the total period for which the interest rate is fixed does not exceed 3 years (see ‘Term of the loan’ below)

Term of the loan Variable interest rate loan (original) – 7 year maximum loan term

Variable interest rate loan (re-financing) – maximum loan term is 7 years less the duration(s) of any previous loan(s) relating to the collection of assets

Fixed interest rate loan – a new LRBA commencing after publication of these guidelines may involve a loan that has a fixed interest rate set at the beginning of the arrangement. The rate may be fixed up to for a maximum of 3 years, and must convert to a variable interest rate loan at the end of the nominated period. The total loan term cannot exceed 7 years.

For an LRBA in existence on publication of these guidelines, the trustees may adopt the rate of 7.75% as their fixed rate, provided that the total period of the fixed rate does not exceed 3 years. The interest rate must convert to a variable interest rate loan at the end of the nominated period. The total loan cannot exceed 7 years.

LVR Maximum 50% LVR

If more than one loan is taken out to acquire (or refinance) the collection of assets, the total amount of all those loans must not exceed 50% LVR.

The market value of the collection of assets is to be established when the loan (original or re-financing) is entered into.

For an LRBA in existence on publication of these guidelines, the trustees may use the market value of the asset at 1 July 2015.

Security A registered charge/mortgage or similar security (that provides security for loans for such assets)
Personal guarantee Not required
Nature and frequency of repayments Each repayment is of both principal and interest

Repayments are monthly

Loan agreement A written and executed loan agreement is required

[1] Interest is to be calculated monthly on a compounding basis.

[2]Interest is to be calculated monthly on a compounding basis.

So, what happens if you can’t fit your arrangements into the Safe Harbours?  You aren’t sunk just yet.

LET’S CONSIDER THE LOAN TERMS…

If your client borrowed from a commercial lender to on-lend to the SMSF, what does the commercial lender’s terms to the client look like?

To keep this simple, let’s create a reference:

Client Pty Ltd, as Trustee for Client Superfund, borrows from John Smith, the sole director of Client Pty Ltd and sole member of Client Superfund, to acquire Greenacre for $500,000.  John borrowed $530,000 from Awesome Bank, secured against his home, on a 30 year interest free term, with the first 5 years being interest free only, with principal and interest from year 6.  John gave a personal guarantee, and also offered up security against his personal share portfolio.  The LVR was 80% of the combined value of John’s home and his share portfolio.  The interest on the loan is variable, based on Awesome Bank’s published rates.  Awesome Bank has their own internal assessment processes for determining variable rates.  John’s advisor told him that he could on-lend at the Awesome Bank’s rate for the full acquisition value, on matching loan terms.  John’s advisor also made sure John registered a mortgage over the property.  What happens now?

Can John rely on Awesome Bank’s terms to escape the Safe Harbours?  Not entirely.

Awesome Bank has recourse against John’s income as well, as the security and later acquired assets of John (through the personal guarantee).  John only has recourse against the real property owned by the SMSF, and nothing else.  Accordingly, given the additional risk, one would expect a commercial lender in John’s position would have either required higher interest rates, shorter terms or a varied LVR.  However, the terms of Awesome Bank’s lending to John are nonetheless material; the first approach for John is to seek out Awesome Bank’s LRBA terms.  If Awesome Bank’s LRBA terms at the time of acquisition were more lenient than the Safe Harbour provisions, John has a commercial “arms’ length” reference to hold to support a variation from the Safe Harbour.  However, to the extent his LRBA terms are more favourable than the Awesome Bank’s LRBA terms, John would need to vary his own LRBA to match (even if the variation was less than the Safe Harbour provisions).

What if Awesome Bank did not offer LRBA lending at the time of acquisition?  Perhaps John could then look to Community Bank instead.  If Community Bank has lending terms which were more lenient than the Safe Harbour provisions, then John would have a commercial “arms’ length” reference to support a variation.

To the extent John tries to find “arms’ length” terms different to the Safe Harbour provisions, he is best to ensure the comparative is truly “commercial”.  John should not look to his best mate Bob, who is a third party lender, to provide the “commercial” comparative – unless Bob is a recognised credit provider who has engaged in LRBA arrangements as a regular component of his business (which business commenced well before the publication of ATO ID 2015/27 and ATO ID 2015/28).

LET’S CONSIDER SOME STRATEGIES…

Let’s say that John has to figure out how to raise the shortfall in the LVR.  What are some options?

  1. John could make additional concessional and non-concessional contributions (subject to the contribution caps and restrictions) by allowing part of the loan to be paid down (do not forget the paperwork and required transactions!);
  1. John could invite new members to the fund and their rollovers and/or contributions could be used to reduce the loan (make sure the investment strategy is considered for each);
  1. John could sell the asset (which could be difficult by 30 June – but it is an option); and/or
  1. John could re-finance through Awesome Bank, and give Awesome Bank a personal guarantee (hopefully Awesome Bank values his business).

What if John is in pension phase, and he has to fund increased repayments on the LRBA from the SMSF?  John could look to any of the above options, and he could also:

  1. Commute his pension and roll back to growth phase;
  1. Commute his pension, and commence a part pension with the balance of his member interest in growth phase; and/or
  1. Vary the terms of his pension to reduce his payments to the statutory minimums.

PCG 2016/5 is not the end of the world, but it is a wake-up call to all advisors in the SMSF space to favour conservatism in strategies.  There may be litigation which flows out of PCG 2016/5, given some advisors made exceedingly ambitious strategic recommendations to clients who will not be able to float adequate remedial action by 30 June 2016.  The ATO has given advisors a bit of leeway and, with a bit of creative manoeuvring, many SMSFs can sail to the Safe Harbours with minimal frustration (consider the above options, if the client could fund to lend – the client may likely remediate by treating funds as contributions).

If you would like to discuss PCG 2016/5 or what the ATO Safe Harbours mean for you or your clients, please contact Katrina Brown on 07 5574 3560 or via email.