What to do?

Trustees (and their SMSF advisers) must do two things.  The first is to determine whether their LRBA is a commercial or non-commercial arrangement.  The second (assuming that the LRBA is non-commercial) is to identify any offending elements of the arrangement and to determine what rectification actions should and can be undertaken.  Any rectification action must be completed by 30 June 2016.

How to determine whether an LRBA is non-commercial?
The primary indicator is the identity of the lender.  If the lender is not a commercial lender then the LRBA will be a non-commercial arrangement.  If the lender is a bank or other commercial lender then the elements of the arrangement will necessarily be on arms’ length terms.  A commercial lender would include an unrelated private lender whose goal is to profit from the loan arrangement and therefore whose terms are not typical of those available in the market. Where the lender is a commercial lender, the “safe harbour” parameters are not relevant.

This means (in the case of real estate) that:

•    the term of the loan could be greater than 15 years;
•    the loan could be fixed for a period of greater than 5 years;
•    the LVR could be higher than 70%;
•    the security could be less than a legal registered mortgage provided.

Where the lender is not a commercial lender, it will be necessary to review the relevant elements of the loan to identify any elements which do not match the relevant guidelines.

How to rectify a non-commercial LRBA?
Once the elements which do not match the guidelines have been identified, the issue then is to determine what rectification action is required and whether rectification is even possible.

It may be that only one element of the arrangement needs rectification.  It could be that a legal mortgage has not been registered.  This was often done to avoid incurring loan security duty.  Another example could be an interest rate which is less than the applicable RBA Indicator Rate.

Possibly, the most common element which is likely to not match the guidelines will be a requirement for principal and interest repayments and monthly repayments.   While these are seemingly simple elements to rectify, if these elements have to be rectified from the start of the 2015/16 financial year (or from the commencement of the loan if the loan commenced after 1 July 2015) then a considerable cash flow burden may be imposed on the superannuation fund.

Possibly, the most difficult element to rectify is the LVR of the loan.  If the LVR is substantially in excess of 70% (real property) or 50% (listed securities) then the LVR can only be within the relevant guideline by paying down the loan.  This may simply not be possible given the amount of the required payment and the inability to make substantial contributions to the superannuation fund (because the relevant caps have been exhausted or because capital is not available).  While borrowing in a member’s own right and making a contribution to the fund is possible (contribution caps permitting) the interest on the borrowed money will not be deductible.

What if simple rectification is not possible?
In this case (and it may not be common) the trustee and their SMSF adviser must choose one of the of following courses of action.

Repay the current loan:  repay the outstanding loan amount and extinguish the loan by 30 June 2016.  The asset need not be immediately transferred to the SMSF trustee but could be held indefinitely in the holding trust.  This action presupposes that the SMSF has sufficient cash resources to repay the debt – either from new contributions or by liquidating other assets

Re-finance the arrangement: take out a new loan from a commercial lender which is used to repay the current loan.  The issue with this response is that often non-commercial lending arrangements were used as commercial lenders did not find the arrangement attractive.  Consequently it may not be possible to re-finance the loan with a commercial lender

Close out the arrangement by selling the asset:  this may not be feasible if the asset is a business critical asset.  In the case of real estate, closing out the arrangement may generate a capital loss or the sale is a forced sale in unpropitious market conditions. And don’t forget the timing, so if you’re thinking of doing this you’d better get cracking to meet the 30 June deadline

Defend the arrangement against ATO scrutiny:  this would involve benchmarking the loan against market conditions (and retaining sufficient evidence of the benchmarking process for review by the fund’s auditor and maybe the ATO)

Dispute the determination of the amount of NALI:  this involves accepting that the LRBA is non-commercial but challenging the ATO’s view that the non-commercial terms taint the entire income arising from the arrangement.  This would be a noble and courageous response.

Accept NALI status of the income but the amount of tax is not material:  this may be because the net income from the arrangement is minimal, or that the property is negatively geared or even that the fund has substantial tax losses which can be offset against the income.  It may be that paying tax at 47% is less burdensome than other rectification action such as closing out the arrangement.  Two points need to be made.  The first is that the 47% tax rate is applied to the net amount of income arising from the LRBA.  It may be that the interest expense on the loan (and other expenses directly associated with the property) substantially reduces or eliminates the net income so that tax burden is bearable compared to other possible courses of action.  Second – it is not only the income generated by the property which is treated as non-arm’s length income – but also any capital gain as well.  Ultimately the capital gain may be taxed at 47%.

Accept NALI status of the income but rectify the arrangement in the future:  while the burden of tax at 47% may be an acceptable cost it is highly questionable whether the ATO will treat any rectification in the future as being acceptable – particularly where the rectification occurs just before there is a disposal of the asset.  The release of the guidelines is part of the ATO’s response to non-commercial and incorrectly structured LRBAs which involves a grace period in which to either correct or terminate the arrangement.  The good grace of the ATO is not likely to exist after 30 June 2016.  The ATO may take the view that any capital gain arising on the disposal of the asset is liable for tax at 47% (even if the disposal occurs while the superannuation fund is in pension phase).