In recent months, there have been a number of developments relating to self-managed super fund (SMSF) limited recourse borrowing arrangements (LRBAs). For SMSF clients contemplating entering into any type of LRBA in the foreseeable future, the recommendations of the Financial System Inquiry panel (FSI) may influence current planning because, although not government policy, the recommendations may lead to new legal restrictions on LRBAs during the course of the next year or so.
For clients exploring the prospect of arranging a low-interest SMSF borrowing from a related party, the Australian Taxation Office’s (ATO’s) recent interpretative decisions ID 2014/39 and ID 2014/40 will also be of immediate interest.
Other clients will be concerned about recent ATO statements that cast doubt on the use of cross-insurance arrangements to support fund borrowings, while many will be comforted to know that the government has released draft legislation to clarify the income tax treatment of instalment warrants and LRBAs.
Government’s response to the FSI
The FSI has effectively recommended the complete removal of the ability of super funds to establish LRBAs to purchase fund assets. Broadly, the FSI believes that the removal of LRBA leverage would reduce super system risk. More specifically, it doubts whether LRBAs are genuinely “limited recourse” by nature, particularly where supported by personal guarantees. It has also expressed concerns about LRBAs’ effect in reducing diversification and in circumventing contribution caps.
The key question is how the government will respond to the FSI’s recommendations. Will it go so far as to completely remove the scope for LRBAs? Will it instead adopt a “middle ground” by introducing a combination of specific constraints on LRBAs? For example, FSI submissions of various industry stakeholders suggested constraints such as:
• Prohibiting personal guarantees
• Limiting loan-to-value (LVR) ratios or the amount that could be borrowed
• Requiring the terms of all loans to be completely commercial (not required under the current “arm’s length rule” – that is, section 109 of the Superannuation Industry (Supervision) Act 1993 (SIS))
• Imposing consumer protection requirements on relevant licensees offering advice and products, along the lines originally proposed as part of the previous government’s Stronger Super package.
Timing the transition
Assuming the government ultimately decides to impose new constraints on LRBAs, there is a good chance existing arrangements will be grandfathered, as recommended by the FSI. Inevitably there will be issues to consider about the extent of grandfathering, such as the scope to refinance a borrowing down the track et cetera. Some commentators have even suggested putting related party loans in place now to address grandfathering issues that may arise if an existing arrangement with a commercial lender is required to be repaid early. However, the need for, or effectiveness of, such arrangements is difficult to predict in advance of any government announcement.
As for the timing of any new constraints, it is unlikely that these will be announced or take effect before the government has received submissions responding to the FSI. Submissions need to be lodged by March 31, 2015, which may suggest that a government announcement on LRBAs is unlikely before the May budget statements. Whatever the timing, SMSF clients contemplating entering into an LRBA would need to be confident they have a grandfathered arrangement in place before any cut-off date.
Ideally, the loan documentation would be completed, money borrowed and asset purchased. There may be issues if, for example, a trustee contracts to acquire real estate (perhaps off the plan) some time in advance and the borrowing arrangements have not been sufficiently advanced by the cut-off date. Incidentally, it seems reasonable to assume that instalment receipt arrangements that do not involve a borrowing for the purposes of SIS are unlikely to be affected by any new constraints.
Non-arm’s length arrangements
In December 2014, the ATO released two interpretative decisions – IDs 2014/39 and 2014/40 – each of which dealt with the question of whether a particular related-party LRBA generated non-arm’s length income (NALI), which is taxed at 47 per cent in the hands of the relevant SMSF.
Each LRBA involved payment of interest at a rate lower than the rate that would have applied if the lender had been a commercial provider. In both cases the ATO concluded that the income derived from the investment was NALI as it was greater than it would have been had the parties been dealing with each other at arm’s length. Each arrangement involved a number of characteristics that might be said to have been non-commercial. The ATO did not indicate the extent to which any particular feature contributed to its conclusion.
In the absence of further guidance from the ATO, it would seem that clients entering into a related-party LRBA need to align its terms as far as possible with those of a commercial arrangement. Unfortunately, it won’t always be obvious that an arrangement meets the commerciality benchmarks that need to be met to avoid adverse tax treatment. In particular, it may not always be clear what level of security a bank may require in a particular situation and how that might affect the interest rate charged. For example, would a bank seek a personal guarantee? If so, does it make commercial sense for someone to provide the guarantee? In some cases, therefore, it may be appropriate to apply for a private binding ruling.
Cross-insurance arrangements
An SMSF with a sizeable LRBA for a geared asset may need to address the risk of having insufficient liquidity to repay the loan or pay out cash benefits on the death or disability of one of the members. One solution that has been widely canvassed is for the governing rules of an SMSF to provide that the proceeds of insurance on the life of one member will be payable to the other member’s (or members’) account(s) if the insured event occurs. That is, unlike typical super insurance arrangements, under this solution insurance proceeds aren’t paid out as an additional benefit for the disabled/deceased member; rather, they provide fund liquidity and potentially remove the need for the geared asset to be sold.
The idea that Member B’s account can be credited with the proceeds of insurance over Member A is consistent with an approach that treats the insurance arrangement much like any SMSF investment: the premiums represent investments and the proceeds represent a return on investments. The premiums are deducted from Member B’s account and any relevant proceeds are credited to it. The minutes of the December 2012 National Tax Liaison Group (NTLG) Super Technical Sub-group meeting did seem to indicate that the ATO was comfortable with such an approach.
However, at that stage the ATO had not considered the impact of a relatively new insurance-related operating standard in SIS. That standard provides that, from July 1, 2014, insured events covered under insurance policies taken out by super funds in relation to members must be consistent with the super law conditions of release for death, terminal medical condition, permanent incapacity and temporary incapacity. The ATO has recently turned its attention to that standard and concluded (in a seemingly unheralded statement on its website) that “cross-insurance arrangements where the proceeds of an insurance policy are paid to someone other than the insured under the policy are not permitted”, citing a comment in the explanatory memorandum that accompanied introduction of the standard as the basis for its view.
While professionals are likely to seek a more fulsome explanation of the ATO’s view on the subject, for the time being cross-insurance does not appear to be an acceptable solution to the LRBA liquidity issue outlined above. If the ATO maintains its current position, there may be lobbying to amend the law so that it clearly allows cross-insurance to support LRBAs – but success may be difficult, given the current policy climate.
Removing a layer of taxation
On a positive note, in January 2015 the government released draft legislation to provide “look-through” income tax treatment for instalment warrants, instalment receipts and LRBAs through super funds. This measure was originally proposed in March 2010. In practice the ATO already generally ignores the security trustee of LRBAs for income tax purposes; but under the current law, there has been doubt about whether it should in many cases. Essentially, for an LRBA, if enacted the provisions would treat:
• the SMSF trustee as the owner of the geared asset rather than the security trustee, and
• acts done by the security trustee as having been done by the SMSF trustee. This would avoid a double-up of capital gains tax (CGT) events and ensure that income derived from the geared asset would be attributed directly to the SMSF trustee who could offset all relevant deductible expenses and franking credits. If enacted, the provisions would apply from the 2007-08 year onwards for all compliant LRBAs (including those that were established under the now repealed section 67(4A) of SIS).
It may be timely for SMSF clients with LRBAs to review their position with regard to future compliance, taking into account recent developments. Those contemplating entering into an LRBA also need to consider the possibility of future legislative constraints and the timing and associated risks.
