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SMSFs are allowed to borrow from a related party
The ATO states that the law does not prohibit the lender from being a related party. However, SMSFs must continue to comply with other legislative requirements. For example, the SMSF must satisfy the sole purpose test and comply with existing investment restrictions such as those applying to in-house assets and prohibitions on acquiring certain assets from a related party of the fund.
To know whether it is acceptable for related parties to lend to an SMSF on favourable terms, including 0% interest rates it is necessary to consider the full implications of the non-arm’s length income provisions in section 295-550 of the Income Tax Assessment Act 1997 (Cth).
Non-arm’s length income provisions
Broadly, income is non-arm's length income of a complying SMSF if:
- it is derived from a scheme or investment in which the parties were not dealing with each other at arm's length, and
- that amount is more than the amount that the SMSF might have been expected to derive if those parties had been dealing with each other at arm's length.
"Non-arm’s length income" is taxed at 45%.
ATO's position
The following comes from minutes of the June 2012 National Tax Liaison Group as tabled at the December meeting:
· The ATO position on low rate loan arrangements and LRBA is that
that they do not generally invoke a contravention of the SISA, 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.
· Taxpayer Alert 2012/7 was released on 20 November 2012 to
warn SMSF trustees and advisors to exercise care to ensure any arrangements
entered into by an SMSF to invest in property are the right investment for
their SMSF and are properly implemented, particularly those involving LRBA or
the use of a related unit trust. See also our earlier post: Beware! SMSF investing in Property
· Issues and concerns of low rate loans and LRBA will be
submitted to the review of borrowing. The ATO will be providing comments for
the review when it commences. This is likely to form part of the new Commonwealth Government's tax review although details are not yet to hand.
The ATO recently considered this in two private binding rulings (see 1012414213139 and 1012396819768). These rulings involved SMSFs that had 0% interest rate loans from related parties. In both the ATO concluded that the income derived was not non-arm’s length income which is positive news for those taxpayers. However, private rulings are not binding on the ATO and the full details are not always made public.
Take care and get a Ruling
Although limited recourse borrowing arrangements (LRBA) are becoming more common, care must be taken, especially with related party loans. Particular care should be taken in respect of non-arm’s length income given the tax consequences.
If an SMSF wants to engage in a related party borrowing transaction with favorable terms for the SMSF (ie, non-arm’s length terms) you must apply for a private ruling from the ATO and it is likely that such a ruling would only be applicable for 12 months.
It would not surprise us if in time s. 109 of the SIS Act (investment at arm's length) is amended to include related party loan transactions at market value.
It would not surprise us if in time s. 109 of the SIS Act (investment at arm's length) is amended to include related party loan transactions at market value.
