Since the ability for SMSFs to borrow to purchase an asset was introduced in 2007, LRBAs continue to represent a relatively low proportion of overall SMSF assets. The latest ATO 2017-18 annual statistics confirm that in 2018, 10.2% of SMSFs reported an LRBA which is up slightly from the 9.5% reported the year before. These LRBAs accounted for 92% of the total value of borrowings reported by SMSFs in 2018 which is also an increase from the prior year of 89%.
The latest ATO statistics confirm that of the $43.4 billion of assets owned through an LRBA, 96% is made up of real property, with nearly an even split between residential and commercial property. With so many SMSFs exposed to real property, it was no surprise that as more tenants affected by COVID-19 were granted rental relief, the pressure was building on SMSFs’ ability to meet loan repayments where an LRBA was in place. This pressure was compounded for SMSFs in pension phase that also must ensure minimum pension payments are made.
As part of a range of compliance relief offered by the ATO to SMSFs impacted by the pandemic, the Regulator confirmed that temporary loan repayment relief was available to trustees impacted by COVID-19 with a complying LRBA in place, without attracting the operation of the non arm’s length income (NALI) provisions.
This relief should not be considered carte blanche for SMSF trustees to do as they deem fit with respect to LRBA’s.
Existing LRBA versus new LRBA
At the core of the relief is that an SMSF trustee needs to evidence that due to the financial impact of COVID-19 they are unable to meet loan repayments. This means that this relief only applies to existing complying LRBAs in place at the time of the pandemic and should not be relied upon by trustees as an opportunity to enter into new related party borrowing arrangements to take advantage of deferred interest repayments.
For example, given the current economic environment, some small business owners may be tempted to acquire or transfer their business premises into their SMSFs using a LRBA. Not only will this allow trustees to enjoy some tax advantages such as interest and borrowing expenses being generally tax deductible, but the sale to the SMSF will release some otherwise preserved superannuation benefits to a related entity.
The SMSF Association has continually noted the importance of LRBA strategies for small businesses investing in real property and the flexibility they bring when used appropriately. However, trustee’s entering into new LRBA’s with related parties, in the current environment, should do so cautiously to ensure that the sole purpose test is not at risk.
Total Superannuation Balance (TSB) implications should also not be overlooked as all new LRBA’s with an associated lender, from 1 July 2018 will see all members’ whose interests are supported by the LRBA asset, have their TSB adjusted to reflect their share of the outstanding balance of the loan. The inflation of a member’s TSB in turn limits a member’s ability to make non concessional contributions and catch up concessional contributions which may impact a fund’s ability to meet loan repayments.
Loan relief versus refinancing
The ATO’s relief only offers SMSF trustees with short term cash flow assistance where the relief provided is consistent with what commercial banks are offering. The ATO’s relief refers trustees with either residential or commercial property, to the Australian Banking Association’s (ABA) landlord relief package as a guide to an arm’s length arrangement.
This guide confirms that landlord’s relief includes the temporary deferral of loan repayments for up to six months. The guide confirms that whilst a landlord won’t have to make any principal or interest payments for the six months, interest will continue to be accrued and will be capitalised.
This means that SMSF trustees need to have clear evidence in place that interest continues to accrue on the loan and that there is an agreement in place to catch up on any outstanding principal and interest repayments as soon as possible. Furthermore, there needs to be evidence that there have been no changes to the actual interest rate that is being charged on the loan and no extension to the term of the loan itself.
At this stage, the ABA’s code acknowledges that the length of a commercial loan can be extended where agreed to between the landlord and the lender. To date the ATO has been silent on this point so until further guidance is provided, it is best to proceed on the basis that the term of the loan will generally not be able to be extended. If we fast forward to the end of the standard six month deferral period, the SMSF trustee will be required to make larger monthly repayments, in order for the loan to be repaid in full, by the end of the loan term. Ordinarily this inflated expense would be considered non arm’s length and discussions are underway with the ATO to consider whether a further extension to their ‘no compliance’ approach is warranted.
This is not to say that an LRBA cannot be refinanced. Where SMSF trustees opt to refinance an LRBA it is important to restructure on arm’s length terms or in accordance with PCG 2016/5 to avoid the risk of the NALI provisions applying.
Where an SMSF trustee is considering refinancing, it is also important to review the loan agreement to determine whether a penalty interest provision is included. Although this is not a feature of a related party loan agreement prescribed by PCG 2016/5, it is possible one exists and could be triggered if the SMSF repays a loan early or refinances.
PCG 2016/5 new 2020 -21 interest rate announced
Where an SMSF has chosen to apply the ATO’s safe harbour provisions, it is important to note that the capitalised interest during any loan repayment deferral period reflects the correct interest rate.
The rate used by the ATO is the Reserve Bank of Australia (RBA) Indicator Lending Rate for banks providing standard variable housing loans for investors, based on the published rate in May each year. For the year ending 30 June 2020, the relevant interest rate is 5.94% p.a. whereas from 1 July 2020 the interest will accrue at the reduced 2021 rate of 5.10% p.a.
Division 7A complications
Finally, the complexity of any loan relief available to an SMSF is compounded where the LRBA is financed by related parties who must also comply with Division 7A requirements. Essentially, if the lender is a company (or even a trust in certain circumstances), unless the loan meets strict criteria which includes the need to make a minimum annual repayment it is at risk of being deemed a dividend.
Traditionally, an LRBA with a potential Division 7A issue needs to meet both Division 7A criteria and the ATO’s PCG 2016/5 to ensure the loan is not deemed a dividend under Division 7A and is on arm’s length terms as required under the SIS and Tax Act. When compared to the requirements under Division 7A, the PCG currently allows for a higher interest rate, allows a shorter maximum term, sets a lower maximum loan to value ratio, and requires a mortgage to be registered. Therefore, given the ATO’s safe harbour guidelines are more restrictive, best practice has been for trustees to follow the safe harbour guidelines to ensure the loan satisfies both criteria.
Where COVID-19 has affected an SMSF’s ability to make the minimum annual repayment required for Division 7A purposes by 30 June 2020, the ATO has confirmed that an online application can be made to the Commissioner to request an extension of time to pay any shortfall.
On approval, the SMSF will have until 30 June 2021 to pay any 2019-20 shortfall plus the minimum annual repayment required for the 2020-21 year. The Commissioner’s extension of time does not alter or amend the terms of the loan agreement between the SMSF and the related entity. What is important to highlight is that the ATO’s Division 7A relief in relation to COVID-19 does not allow any unpaid interest on the loan for the 2019-20 year to be capitalised.
Division 7A reforms
As we approach 1 July 2020, the broader Division 7A reforms first announced as part of the 2017 Budget, remain in limbo. It is unknown whether a start date of 1 July 2020 will apply or whether there will be a deferral to allow for further consultation.
The SMSF Association has already flagged with the ATO the potential need to review PCG 2016/5, once we see draft law. In the meantime, it is important for industry to be aware that these Division 7A reforms have the potential to give rise to larger loan repayments than currently allowed under the PCG.
For example, under the proposed Division 7A rules, the maximum term of a loan will be as low as 10 years when compared to a maximum term of 15 years permitted under the PCG. Furthermore, the proposed interest rate for Division 7A loans is set to change benchmarks and will result in a significant increase. The benchmark interest rate is currently 5.37% (2019-20) but under the proposed changes it will be linked to the RBA Small business; Variable; Other; Overdraft lending rate published by the RBA at the start of each year (currently 6.57%). This is greater than the PCG variable rate which has just been revised down to 5.1% for 2020-21.
With SMSFs now relying more on related parties to finance LRBAs following the exit of the big banks from the SMSF loan market over the past few years, it is essential to ensure these arrangements are established and maintained at arm’s length at all times to avoid NALI. In the current environment where constant change makes it difficult to benchmark to a ‘normal’ commercial arrangement, it may be prudent to rely on the ATO’s safe harbour provisions in PCG 2016/5 which continue to apply.
At this year’s SMSF Association Technical Day we have a dedicated session on LRBAs. Bryce Figot, Special Counsel, DBA Lawyers and Julie Steed, Senior Technical Services Manager, Australian Executor Trustees will provide a detailed examination of the impact that COVID-19 and legislative changes have had on popular LRBA strategies. To register for the SMSF Association Technical Day please click here.
Mary Simmons, Technical Manager