The biggest change – or more accurately the biggest non-change – in the government’s recent response to the Financial System Inquiry (FSI) is its decision not to act on a recommendation to “remove the exception to the general prohibition on direct borrowing for limited recourse borrowing arrangements [LRBAs] by superannuation funds”.
More specifically, the final FSI report – released in December 2014 – stated that the government should “restore the general prohibition on direct borrowing by superannuation funds by removing Section 67A of the Superannuation Industry (Supervision) Act 1993 (SIS Act) on a prospective basis”.
It described the problem as follows: “Growth in superannuation funds’ direct borrowing would, over time, increase risk in the financial system … [and] the Inquiry notes an emerging trend of superannuation funds using LRBAs to purchase assets. Over the past five years, the amount of funds borrowed using LRBAs increased almost 18 times, from $497 million in June 2009 to $8.7 billion in June 2014.”
Naturally, this was a cause for concern for many in the self-managed super fund (SMSF) industry. Some felt that the recommendation unfairly targeted all LRBAs when only some or a minority posed any concern. Of course there are risks with any borrowing, but I have seen carefully planned and meticulously implemented LRBAs greatly add to an SMSF’s ability to provide retirement benefits while adding only a commensurate amount of increased risk for the increased return.
The recommendation was a particular concern for those whose SMSFs had signed contracts to buy properties off the plan. Typically with such purchases, the wait is well over a year before the apartment is built and a bank is ready to execute loan documentation. If the government changes the law in the meantime, such SMSFs can be left in a tricky position.
Luckily, the government has adopted a “wait and see” approach. More specifically, on 20 October, the government responded to the FSI as follows: “The Government does not agree with the Inquiry’s recommendation to prohibit [LRBAs] by superannuation funds.
“While the Government notes that there are anecdotal concerns about [LRBAs], at this time the Government does not consider the data sufficient to justify significant policy intervention.”
Accordingly, LRBAs are still allowable … at least for the time being.
Bank policies
The past 12 months have seen a marked increase in difficulty in gaining agreement from a bank to lend to SMSFs. Some banks appear to give a flat-out refusal to lend for new LRBAs to acquire residential real estate. It is too soon to say with certainty, but since the government has not banned LRBAs, hopefully major banks will re-enter the residential LRBA market.
New tax legislation
The passing of the Tax and Superannuation Laws Amendment (2015 Measures No. 2) Act 2015 was a positive change. It clarifies that a look-through approach can be applied to a holding (or “bare”) trust that is a mandatory feature of LRBAs.
This new law inserted into the Income Tax Assessment Act 1997 is around the concepts of an “instalment trust” and an “instalment trust asset”. These include, respectively, an LRBA bare trust and the asset that is owned via the bare trust.
The legislation goes on to provide that where an investor (eg, an SMSF) has a beneficial interest in an instalment trust asset under an instalment trust, the asset is treated as being the investor’s asset instead of being an asset of the trust.
It gives the following examples:
. A dividend in respect of the asset is paid to the instalment trust (ie, the bare/holding trustee). Under the new law the dividend is treated as if it had been paid directly to the investor
. A trustee of an instalment disposes of the instalment trust asset. Under the new law the investor, not the trustee, makes any capital gain or loss.
Also, although the changes were inserted into the income tax legislation, they also extend to the goods and services tax (GST). For example, the recently inserted s. 235.820(5) of the Income Tax Assessment Act contains the following example: “If the trustee [of the instalment trust] has a net input tax credit under the GST Act, the [SMSF] must apply the credit to reduce the investor’s cost base for the instalment trust asset (even if the [SMSF] is not registered or required to
be registered for GST purposes).”
In truth though, many were not too excited by the passing of the Tax and Superannuation Laws Amendment (2015 Measures No. 2) Act 2015, as it simply confirmed what has already been industry practice for many years.
Related-party lending
Naturally, it is possible for the lender to an SMSF to be a related party. In 2010, in Australian Taxation Office Interpretative Decision ATO ID 2010/162 the ATO stated that “there is no contravention of section 109 of the [SIS Act] if the terms [of a related party SMSF loan] are more favourable to the SMSF [than had the parties been at arm’s length]”.
Then, the National Tax Liaison Group (NTLG) Superannuation Technical minutes of June 2012 recorded that the following two questions were put to the ATO:
“If a related party lender offers a discounted rate of interest to an SMSF under a section 67A borrowing arrangement, would the discount be considered a contribution received by the SMSF?”
And: “Can an SMSF enter into a borrowing arrangement … with a related party if a zero rate of interest is charged by the related party lender and only principal repayments, with no imputed interest, are made throughout the loan term in accordance with the loan agreement?”
The ATO answered both in terms favourable to taxpayers (ie, no to the first and yes to the second).
Further, in the general NTLG minutes of December 2012, the ATO stated: “The ATO position on low-rate loan arrangements and LRBA is that that they do not generally invoke a contravention of the SIS Act, do not give rise to non-arm’s length income under section 295–550 of the Income Tax Assessment Act 1997 (ITAA), do not invoke Part IVA of the ITAA 1936 and are not considered to give rise to contributions to the SMSF just from that one fact alone.”
Accordingly, many had read this as giving carte blanche for low – or even nil – interest related-party LRBAs. At DBA Lawyers, we had never been fans of such arrangements, and of course ATO comments in NTLG minutes are not binding.
Then, in December 2014 the ATO released Australian Taxation Office Interpretative Decisions ATO ID 2014/39 and ATO ID 2014/40. These both considered related party LRBAs with nil interest being charged and both stated the ATO’s view that the arrangements did give rise to non-arm’s length income.
Accordingly, the position that DBA Lawyers has long supported – namely, that related party LRBAs should be on the same terms that would be agreed with an arm’s length lender – is now broadly accepted.
Here to stay (for now)
The past year has shown that LRBAs are here to stay (at least for the foreseeable future), but we must remain careful regarding their setup. This care ranges from ensuring that a bank will lend to ensuring that – where there is a related party – the terms of the loan are reflective of what is arm’s length.
